A Good Annuity Comprehensive Guide
What is a “good annuity?” It is an annuity an advanced investor might want to buy! Usually, you are sold annuities, not so with a good annuity.
When considering retirement income, should you use “good” annuities such as SPIAs, DIAs, or QLACs? What do those letters mean anyway?
If you know a little bit about “good” annuities and are considering one, read on for a comprehensive treatment of your options. There are different types of good annuities! These will not be sold to you, so you need to go out and learn about them and sign yourself up. And as a warning: this is a tough read and not meant for a superficial glance. If you are looking for retirement income options via good annuities, you have found the right spot!
What is the Meaning of Good Annuity?
A Good Annuity means a product you seek out and purchase to mitigate risks and provide income as part of your comprehensive retirement plan.
You don’t invest in annuities; you buy them. They are insurance products that transfer risk. This is important to understand. The purpose of a good annuity is to transfer your risk to a risk pool. You trade liquidity for income with good annuities. Remember, despite what wall street tells you, you don’t need to be 100% liquid at all times, and in fact, liquidity comes at a cost.
What risk are you transferring? That you might run out of money!
Instead of possibly running out of money, a good annuity guarantees a stream of income that won’t stop until you (and perhaps your spouse) die. And no, the insurance company doesn’t “win” if you die early. The risk pool wins!
There are mortality credits paid out to you the entire time you take your income stream. What does that mean? Mortality credits are the increase (above bonds alone) in income you get from an annuity because you have pooled your risk. The insurance company knows that some people will die early, and thus they can pay everyone a little more from the very start.
Many fancy, expensive, complicated, agent-sold annuities don’t offer mortality credits. If you are being sold an annuity, chances are there are no mortality credits. A good annuity, on the other hand, feature mortality credits. Again, mortality credits are why you “make more money” with an annuity than if you own just the underlying bonds. Some say: “why own an annuity when you can just buy the same underlying investments as the insurance company does.” Do you understand why that is false? Good.
Let’s dive in and discuss the lineup of GOOD ANNUITIES.
What is a Good Annuity to Buy?
Next, look at the (very few) good annuities to buy. They include:
Single Premium Immediate Annuity (SPIA) is a good annuity
A SPIA is an immediate income annuity meant to provide income and some longevity protection (the risk of running out of income if you live a long life). The income you get every month doesn’t stop until you (or you and your spouse if you purchase a Joint and Survivor Annuity) die.
You get the mortality credits from the time you turn the income on (which must be less than 13 months from the lump sum payment to the insurance company). SPIAs are helpful if you have an income gap now. As they are not inflation-adjusted, you will lose purchasing power with them in the future, so I don’t consider them longevity annuities.
Deferred Income Annuity (DIA) is a good annuity
Another annuity specifically for longevity insurance is a DIA (Deferred Income Annuity). With a DIA, you make an initial lump sum payment but defer turning on the income for several years. In exchange, you get a higher percentage of income when it eventually is annuitized.
You get mortality credits and a bonus for allowing the insurance company to use your money for a while. So, if you have an income gap in 10, 15, or 20 years, a DIA might be suitable for you. This is real longevity insurance because it meets a future income need. If you die before the DIA starts, well, then I guess you don’t have that income need.
DIAs pay more because you irrevocably give the money to the insurance company to use until you turn on the income stream. This means that eventually, they will pay you more per paycheck, which means they are relatively protected against inflation.
Given that DIAs “lock-in” current interest rates when considering future payments, I’m not that excited about them. Another option is a MYGA that you 1035 into an SPIA. This may offer you an equivalent amount of future income with less illiquidity. More about that later.
Qualified Longevity Annuity Contract (QLAC) is a good annuity
Before we get into QLACs, let’s talk about the account type you invest in. Brokerage, pre-tax, or Roth?
A Good Annuity in a Brokerage Account, a Pre-Tax Account, or a Roth?
Remember, there are different account types. There are non-qualified (also called taxable or brokerage accounts) and qualified accounts (pre-tax retirement accounts). And don’t forget Roth, though you need to be careful before putting a good annuity inside a Roth account.
You can buy SPIAs in both qualified and non-qualified accounts. The difference will be taxation of the income stream. This gets complicated quickly, but remember that pre-tax retirement accounts will always be fully taxable.
With a brokerage SPIA, only part of the income is taxable every year. Eventually (hopefully), you get your basis (that is, your original investment) back, and then the pure “growth” becomes fully taxable from then on. The insurance company calculates an exclusion ratio for you, which dictates how much you have to pay each year in taxes. You don’t have to do the math, but taxation can get complicated.
So you can get a SPIA in all three account types.
Until recently, DIAs could only be purchased in your brokerage account. You could not get a DIA in a pre-tax account because of RMD issues. This problem was solved by congress: Enter QLACs.
A QLAC is a Good Annuity, Too!
A newer good annuity is gaining interest: the QLAC (Qualified Longevity Annuity Contract). This is “a DIA for your IRA.”
A QLAC lets you take money (up to $130,000) from your pre-tax retirement account and defer income from it into the future. This is proper longevity insurance, and maybe a consideration for those with a long life expectancy and sizeable pre-tax retirement accounts. You can get joint and survivor payouts, and there are options for period-certain and return of premium as well. So, while there are more bells and whistles with QLACs, they can be an important part of your longevity plan.
Some are excited to use QLACs to decrease Required Minimum Distributions (RMDs). The money you use to purchase a QLAC is not included when calculating RMDs. QLACs actually just delay RMDs, though, and you will pay eventually.
QLACs allow you to defer annuitization until as late as 85 years of age. As a result, they can be an interesting option for longevity insurance and for spouse protection/planning if used as a Joint and Survivor annuity.
Summary: Good Annuity Meaning
We are off to a good start! You can have a good annuity in different accounts. The usual suspects are brokerage accounts and pre-tax retirement accounts, which have different tax implications. Some can consider a good annuity in a Roth account (tax-free income for life!), but be careful using wonderful Roth money in an annuity.
Next, we have the product types. There are SPIAs and DIAs for your brokerage account and SPIAs and QLACs for your pre-tax retirement accounts.
Since we have now had an introduction to the good annuity, I now want to challenge you. Let’s look at a brokerage SPIA vs. a QLAC!
Good Annuity Comparison SPIA vs. QLAC
To familiarize ourselves with these good annuities, I thought comparing them in a fictional couple would be fun.
Let’s start with an immediate income brokerage annuity vs. a deferred longevity IRA annuity. Try to say that fast a couple times. I told you this wasn’t going to be superficial. And now you see why no one likes annuities…
Also, this is not an apples-to-apples comparison, but it provides insight into how these products can be used in retirement.
Later, I will also briefly compare a brokerage DIA and a Qualified SPIA as well. Hold on to your hat cause here we go.
Meet Our Couple
Assume a couple is 74 and 69 years of age. They both have longevity (they plan to live until 95 and 100 years of age, respectively—a 30-year plan) and worry they may not have enough money left.
Current net worth is $2,000,000, and they spend about $7,500 a month—a 4.5% withdrawal rate.
They keep $250,000 in cash and have a 50/50 stock to bond ratio (assuming 6% and 3% growth).
The Roth IRA has $250,000, and there is $750,000 in a roll-over IRA. The rest of the $750,00 is invested in a brokerage account. Assume inflation is 2.5% except for healthcare which is 5%. Finally, they receive $3,000 a month in social security.
Current Plan without an Annuity
Monte Carlo simulation shows only a 53% chance that their plan will succeed. In addition, stress testing shows particular sensitivity to interest rate and longevity risks.
Figure 1 shows the confidence levels that their money will last 30 years. The plan ends at 105, which is when the 69-year-old partner expects to die at 100 years of age, a full ten years after the older spouse passes. You can see the 50th percentile runs out of money at age 104, and the 25th percentile runs out at 99. The 5th percentile is gone at 95. What that means is using historical returns, 5% of the time, there is no money left after 20 years, and 50% of the time, there is no money left after 30 years. Do you like those odds?
This plan upsets the younger spouse, who is determined to live to 100, and they wonder if a SPIA would help.
What about a $260,000 SPIA from the brokerage account? They are offered a 7.2% yearly rate of return on a single life annuity on the younger spouse.
Of course, they can opt for a Joint and Survivor policy, but the younger spouse plans to outlive the older partner by ten years. A single-life policy has higher returns than a joint policy, making sense as you are only insuring one life. The percentage return depends on age, gender, and current interest rates.
With a $260,000 SPIA, the couple now has a 60% chance for success on Monte Carlo Simulation. That’s a little better than the 53% without a SPIA, but what does that actually look like?
Visualize a good annuity: the SPIA
Figure 2 above shows a drawdown comparison between the two plans. In light green, without a SPIA, their assets decrease slowly over time. In dark green, with a $260,000 SPIA, note their assets decrease immediately as the money is irrevocably paid to an insurance company in exchange for the income stream.
At age 97, the plans “cross over.” That is, they have more remaining assets due to the income from the SPIA after that point. If they live as long as planned, in the end, they have an extra ~$102,000 more left over for their heirs. Take away here: SPIAs can decrease the amount you leave to your heirs if you die before the “cross over” but increase the amount if you live longer than average.
We increase the Monte Carlo odds of success and offer a bit more income stability with a SPIA. What about a QLAC?
In 2021, you can transfer 25% of your IRA (up to a maximum of $130,000) into a QLAC. The couple decided to see what $130,000 from their IRA would buy and were offered a 14.4% rate of return for a 10-year deferral of income. Note the higher interest rate due to the deferral.
Monte Caro simulation for the QLAC is 60%, and an asset simulation is seen below in figure 3.
Compare the asset simulation with a QLAC to no annuity in Figure 1. Note all of the percentiles are shifted to the right by about five years. So, a QLAC does protect you from running out of money if you live too long!
The drawdown comparison is similar to figure 2 above, so not repeated here. The “crossover” point in this example is 99 years of age when the QLAC plan has more assets than the initial plan.
Like the SPIA, the QLAC slightly increases Monte Carlo odds, and both plans lower the risk of inflation and longevity on stress testing.
So—who is the winner of the Good Annuity competition? That is for our couple to decide.
Meanwhile, let’s briefly consider the two other possible combinations for immediate vs. deferred and non-Qualified vs. Qualified.
Running some simulations of a 10-year DIA in the taxable account, the Monte Carlo success rate increases the more you dedicate to the annuity.
We can blow all brokerage accounts on a DIA and achieve a 94% success rate. However, again, the cross-over point is still at age 99. This means that longevity insurance comes at a price. The younger spouse has to live at least 25 years to see the significant initial drop in their brokerage account return to the baseline amount. If the spouse dies before this, there is less money for the kids.
Like the other plan above, for a SPIA in a Qualified account, Monte Carlo success rates increase as you increase the money dedicated to the annuity. We can use the entire $750,000 in the IRA to purchase a SPIA and get up to a 79% success rate.
Figure 4 should look familiar to you. Note the sizeable initial transfer of money to the insurance company results in a significant depletion of assets. This is the cost of longevity insurance. They have to live past 99 to reach the cross-over point.
Summary: A Good Annuity in Different Account Types
I hope that wasn’t too overwhelming, but it is a comprehensive look at an example of a good annuity.
In a nutshell, any of these annuity options (SPIA or DIA) in either account type (Qualified or non-Qualified) increases the odds of success. This is especially true if the couple is willing to use a large sum to purchase the annuity. The risk is that you don’t live long enough to “get your money back.”
Actually, the real risk is that you live too long and run out of money because you didn’t plan for longevity protection. But that is why annuities are so unpopular. You “blow” your money if you die too early. That is why there are mortality credits, which is why annuities work for longevity. That is risk pooling.
Everyone has a better chance of success because some people die early. Honestly, though, there is no more efficient way to plan for longevity. You can’t do it with bonds alone (think about the mortality credits). You can’t do it with a safe withdrawal rate. Roll the dice and see what the Monty Carlo Odds say.
There are tradeoffs involved in any retirement plan.
Of course, you don’t just need to buy one annuity. You can mix and match. Each spouse could get their own (or Joint and Survivor) QLAC from their IRA, with or without a SPIA or DIA from the brokerage account. Planning for income and longevity with multiple annuities is common.
A Good Annuity is Simply a Tool
There is a saying in retirement circles that annuities are simply a tool in your product allocation for retirement. As in all investing, decisions are tradeoffs.
Asset allocation, partial Roth conversions, and delaying social security are examples of tradeoffs between risk and reward. Annuities, when used appropriately, lower both potential risk and possible reward.
For significant current income needs, a SPIA is a good tool. If you have significant longevity risk and may run out of money, a DIA or QLAC can come in handy.
For folks with health and expectations to live a longer than average life, a DIA can help you sleep at night. Annuities have no under-writing or medical exams. Insurance company and other folks in your insurance pool “want” you to die early. You just have to live longer than the actuaries think you will to get your money back. But the point is insurance—not getting your money back. Do any of us complain when we don’t get our death benefits from term life insurance?
Opportunity Cost of a Good Annuity
Of course, there is opportunity cost—the lost opportunity to invest otherwise the money used to buy an annuity. However, no one will guarantee that the stock market will give you a stable, life-long income.
In addition, it is often said that annuities are sold rather than bought. Good annuities, however, are often rather tricky to track down and acquire. They don’t pay substantial commissions compared to the more complicated, bad annuities.
While annuities have strengths, each investor must weigh the guarantees against the money spent. Once you sign up for a good annuity, that money is gone and cannot be used for emergencies or given to heirs.
But, when buying insurance in case you live a long life, do you really want a refund if you don’t?
Next, let’s look at a Good Annuity in an IRA, as this is what most people will consider doing.
A Good Annuity and IRAs
Single Premium Immediate Annuities (SPIAs) are a so-called “good annuity.”
You can buy the good annuity either after-tax (in your brokerage account) or with pre-tax (such as IRA) retirement savings. With the after-tax SPIA, some income is taxable depending on the exclusion ratio. With a pre-tax SPIA, all of the income is always taxable!
Before we get too far into the weeds, why is a good annuity good? Do you want to consider an IRA SPIA?
Why is the Good Annuity Good?
Single Premium Immediate Annuities are NOT like the other annuities on the market.
This is not a Variable Annuity which is expensive and complicated.
This is not an indecipherable Fixed (or Equity) Indexed Annuity with non-guaranteed caps and participation rates. And this is not like the new kid on the sales block: are you being sold a RILA?
SPIAs are simple! In exchange for a lump sum of money, you get a lifetime income stream.
In essence and fact, SPIAs allow you to buy a pension.
They are so simple and easy that the insurance “advisor” doesn’t sell them because the commissions are low. It is said that annuities are sold, not bought. That is true for most annuities, but not SPIAs!
Consumers want SPIAs because they are the good annuity. They are bond replacements in your asset allocation. But to truly understand what makes a Single Premium Immediate Annuity the good annuity, you must understand mortality credits.
Mortality Credits make SPIA a Good Annuity
Without being too morbid, we are all going to die! Insurance companies know that, and they take advantage of that fact. They actually play both sides of that coin.
Insurance companies sell life insurance which pays out when someone dies. On the other side of the coin, they sell annuities which STOP paying out when someone dies! So, insurance companies can hedge their life insurance bets with annuities. Or hedge their annuity bets with life insurance.
When SPIAs sell, they are placed in a “risk pool.” The actuaries know how many people will die each and every year in that pool. They don’t know who will die, but they know how many people in the risk pool die.
When you buy a SPIA, you get mortality credits because the insurance company knows they will pay less and less each passing year. People die; the living keep getting income.
Yes, insurance companies use bonds to cover their liabilities on the good annuity. DIY investors say they can get the same returns as SPIAs because they will just buy the same bonds. But the fact is DIY investors don’t have risk pools; they don’t get mortality credits!
Mortality credits are increased payments that everyone gets because the actuaries know that some people in the risk pool will die off every year. You get paid more (even initially) because the money is at risk.
A Good Annuity’s Largest Downside
And that is the good annuity’s largest downside. Your money is at risk.
If you die, the lump sum you turned into income dies with you!
Folks can’t seem to get over that fact, which leads to the annuity puzzle.
I want you to recognize that losing your money when you die is a good thing! Seriously, it is what gives you mortality credits and an increase in payment ABOVE what you can get from bonds! As you survive longer than the actuaries expect you to, you continue to benefit from the higher income that similar bonds alone can provide. All because of mortality credits.
An Example of a SPIA in an IRA
Let’s look at the Good Annuity in an IRA. You can transfer your retirement money into a SPIA at an insurance company. This is called an Individual Retirement Annuity.
Consider a single male aged 65 who desires lifetime income. He has social security, $500k in a brokerage account, and a $1M IRA.
He is smart, so he avoids expensive, complicated Variable and Fixed Indexed Annuities. Instead, he desires to have secure, guaranteed lifetime income and is looking at a qualified SPIA.
What happens if he invests a quarter, half, three quarters, or all of his IRA into a SPIA?
Lifetime Income from an IRA SPIA
First, how much income will he receive?
Income in retirement is essential! Let’s see what $250k or $1M can buy for lifetime income with a SPIA.
Purple represents stable income from social security. Annuity income is in mauve, and withdrawals from the IRA are in orange.
His social security is $24,000 a year and has a cost of living adjustment indexed to a measure of Consumer Price Index. About 24% of his retirement income goals are met from social security.
The $250k SPIA on top adds $17,000 a year, an amount which is not cost of living adjusted. Now, about 36% of the income is stable.
For the $1M SPIA, $68,000 a year is paid, and 70% of the income is stable.
Assuming his inflation is 2% per year, you can see the withdrawals slowly increase over time. It is important to note the withdrawals are quite small in the beginning, giving time for the tax-deferred investments to grow to meet the future income demands!
In addition, his income will never fall below 36% or 70% of his “needs,” which is important. In this case, needs include both floor expenses (rent, food, gas, electricity, etc.) and desired spending goals (such as eating out, travel, etc.). Spending in retirement is lumpy and usually goes down over time aside from health care needs which tend to spike in the very late years.
Some of you are probably looking at the increasing income needs over time and wondering how he will afford all those withdrawals and a SPIA. Well, what effect does the purchase of a SPIA have on his portfolio value?
Visualizing Total Portfolio Value with a SPIA
Let’s look at the value of his portfolio with and without SPIA in the IRA. We know he had a $1M IRA in addition to $500k in a brokerage account to start.
Above, you can see the total value of the portfolio over the years.
On top, a $250k IRA SPIA is demonstrated in green vs. no SPIA in lime. With the initial purchase, the portfolio value drops by $250k. Note, however, that the SPIA pays off over time as there are fewer withdrawals from his investments. The ending portfolio values are nearly identical after 35 years.
On the bottom, $1M is spent on an IRA SPIA. In this setting, given the stable income from the SPIA, the portfolio value actually increases over time! This is because the withdrawal rate on the remaining portfolio is small, so the remaining investments grow more rapidly.
Over time, despite 2% inflation, there is almost no decrease in his portfolio size over time. This is good to know as some folks are worried about legacy if they use a SPIA. In this example, you pretty much know how much you have to leave behind with a SPIA.
Many people want to leave behind a legacy. In fact, that is a prominent issue in the annuity puzzle; let’s look at it more closely.
If you buy a SPIA, how much will you leave behind? Probability distributions can help answer that question.
Probability Distributions of Single Premium Immediate Annuities
Again, on top is $250k IRA SPIA and $1M on the bottom.
The blue line demonstrates the average expected return of remaining assets. In dark blue, 25-75th percentile, and 5-95th percentile in light blue.
On the top, there is a slight dip and the expected amount decreases to zero after 35 years. With the larger initial outlay in the $1M IRA SPIA, the line initially slopes up before slowly decreasing. In fact, there is the expectation of money remaining after 35 years. Stated explicitly, a large SPIA is more likely to leave a legacy after 35 years than a small one! That seems counterintuitive.
The 25%-75% confidence levels are dark blue. This runs out of money at 94 and 97 years on the low side. On the upside, there is about $1M remaining portfolio balance in each plan.
The potential upside of staying invested in the market is seen in the 5%-95% confidence levels in light blue. Here, you may have $3.5M left with the smaller SPIA and $2.5M left with the larger. The downside: you might run out at 86 or 92 years of age.
You can see more upside potential with a smaller SPIA, as there is more market risk. If the market does well, your heirs do well as you have more assets left to chance in the market. However, a smaller SPIA has more downside risk, and counterintuitively, you are more likely to leave assets behind with a larger rather than a smaller IRA SPIA.
Does that solve the annuity puzzle? I doubt it!
Tax Considerations of IRA SPIAs
Let’s move on to taxes!
There are always tax considerations with annuities. This is especially true when required minimum distributions come due.
Let’s look more closely as to why there are more taxes with a Single Premium Immediate Annuity in an IRA.
In green, find yearly tax payments with just social security. You can see they are low until required minimum distributions kick in at 70. Then, at 71, there is another small bump when The Tax Cut and Jobs Act expires. Over time, taxes increases with required minimum distributions. Eventually, they slow down as the distributions eat away at the IRA balance.
With a $1M IRA SPIA (blue), initial taxes are higher as the income from the SPIA is fully taxable. SPIAs from pre-tax accounts (such as IRAs and 401k) are always fully taxable. Taxes stay flat over time as the income from the IRA SPIA satisfies the required minimum distributions.
What are the expected Required Minimum Distributions for each account? Initial RMDs at age 70 are:
- Social security: $45,000
- 250k SPIA: $33,800
- 500k SPIA: $22,500
- 750k SPIA: $11,200
- 1M SPIA: none
So, SPIAs decrease RMDs, but overall, there is an increase in tax liability, especially early.
There must be additional advantages to a SPIA? Let’s look at sequence of return risk and income.
IRA Annuities in the Setting of Sequence of Returns Risk
The most significant risk in retirement is Sequence of Returns Risk.
Let’s see what happens if a sequence similar to 2000-2010 occurs again at the worst time, right at retirement.
Above, see the effect a $250k IRA SPIA (top) and $1M IRA SPIA (bottom) have with Sequence of Return Risk. For both, the light green is social security without any SPIA.
With the small SPIA, there is very little dampening of volatility. There is minimal benefit as well, and the portfolio expires an additional year after social security. Of course, social security continues for both. Social security starts at $24,000 a year and has inflation adjustment. With the SPIA, you get an additional $17,000 of floor income for the rest of your life.
With the large SPIA, there is much less volatility during a bad sequence. Indeed, as you need to withdraw less from your investments during the down years, the income value drifts slightly up. After that, with the stable floor income, there is a prolonged decline in the portfolio value. When the portfolio expires at age 100, you are left with social security and a $68,000 SPIA payment for the rest of your life.
Let’s review and decide if a Single Premium Immediate Annuity in your IRA is a good idea.
Summary Table for the Good Annuity and IRAs
Above, you can see the summary table.
Baseline means no Single Premium Immediate Annuity. Below that: the amount used to purchase an IRA SPIA from $250k up to $1M.
As you can see, Monte Carlo odds increase the more money you use to purchase a Single Premium Immediate Annuity.
The yearly Annuity income amount is next. This Annuity is 6.8% yearly income. The return percentage is from an online annuity website obtained for an IRA SPIA on a single 65-year-old male.
Social security and the IRA annuity provide stable (or floor) income. You see, just with social security, about 24% of the income is stable. A $250k IRA SPIA adds 11.7%, while a $1M SPIA adds 46.4% of stable income. This means $1M provides more than 70% of his expected lifetime income.
Lastly, an IRA Single Premium Immediate Annuity means more taxes owed. See the increase in taxes above the baseline above.
Conclusion: SPIAs in IRAs – A Good Annuity
Well, what did we learn?
Qualified Single Premium Immediate Annuities are SPIAs in your IRA. When you transfer funds from your qualified accounts (IRAs and 401k) to an insurance company, you can purchase a qualified annuity.
SPIAs in IRAs can improve the chances of success in your retirement. Even if you run out of nest egg, SPIAs provide ongoing, guaranteed income while you are alive.
In addition, not uncommonly, you have even more of a legacy with a SPIA than without! While folks are worried about irrevocably “giving” away their money to purchase a pension, it is not uncommon for their heirs to be better off. In addition, a SPIA in an IRA may protect against Sequence of Return Risk.
Taxation is an issue. Single Premium Immediate Annuities from qualified (pre-tax) sources are always taxable. This can have implications on taxation of social security and may cause issues with the tax torpedo.
In the end, you can use pre-tax money to buy an income stream. This income can cover your floor or fixed expenses. These expenses don’t go away with time, and neither does the income from your IRA SPIA.
The Purpose of an Annuity When I Retire
Should I buy an annuity when I retire? It depends on the purpose of the annuity!
Before you do anything with your money, before you invest or buy an insurance product, make sure you understand the purpose of that money. What is the money intended to do for you? Before buying an annuity when you retire, make sure you know the purpose!
I think annuities are good tools if you know what you are doing. Make sure you know the purpose of the money, then you can decide if you should buy an annuity when you retire.
Are Annuities a Good Investment for Retirees?
No! Annuities are not investments! Whenever you purchase an insurance product, you are trading money to access a risk pool. That is, you are pooling your risk with others to mitigate that risk! You don’t invest in annuities; you buy insurance!
Certainly there are good annuities such as SPIAs, DIAs, and QLACs.
It can also be smart to consider longevity insurance.
And there are expensive, inefficient, and frankly bad annuities sold to you.
You buy a good annuity. You are sold a bad annuity. Annuities are not good investments. You buy them when you understand the purpose of the annuity.
What is the Purpose of That Annuity?
Annuities can do quite a lot. Quite too much most of the time! My new favorite saying is: you need to know the purpose of the money before you go out and buy an annuity.
I like annuities and what they can do for you. People live longer and spend more money when they have an annuity. Maybe it is because they want to beat the actuarial assumptions of life span, or perhaps the never-ending stream of income that comes in every month. There is a lot to be said for annuities. And against.
But investments can’t do what annuities do. Let’s talk about what that means and try to understand the purpose of your money you put in an annuity.
Investments Can’t Do What Annuities Do
Remember, you have different pots of money set aside to do different things. This is mental accounting, but it is how we think about money. Investments can’t do what annuities do because they are not supposed to! And in fact, most of the time, annuities are actually bond- alternatives rather than stock-alternatives.
Investments have their place in your portfolio. They are to grow, outpace inflation, and provide you with total returns (which is your income when retired). Bonds stabilize the portfolio and provide funds when stocks are down. And annuities? What do they do?
Well, as I mentioned above, annuities do too much! They are often too complicated.
Keeping things simple, though, let’s break down and review some features of annuities when you retire. First, let’s look at the stock-like aspects and bond-like ones.
Investments Vs. An Annuity When I Retire
When I retire, I’m going to have investments and annuities. I understand the purpose of stocks and bonds. So, if I’m going to replace some of my stocks and/or bonds with annuities, why?
What are the features of annuities when I retire that make me interested?
Stock-Replacement Features of Annuities
Remember, the price of admission for stocks is volatility. Market volatility is a feature of stocks rather than a bug. It is expected, and it is the reason stocks have a premium!
Some folks think that volatility is a risk. For the most part, it is not if you plan to own stocks for 10-15 years. They will almost always outperform most other instruments over that period. The risk is in NOT owning stocks and having your money lose purchasing power.
If folks cannot tolerate volatility because they actually think it is risky, then perhaps there is a role for an annuity. Here, you can consider a variable annuity (VA) which actually invests in actual stocks within an annuity wrapper. This is not an efficient way to gain exposure to the equity market, but if someone cannot tolerate volatility at all, perhaps the long surrender period (illiquidity) of a VA might help behavior. There are less expensive IOVAs (Investment-Only Variable Annuities) available.
Or, consider a Fixed Indexed Annuity (FIA), as they are principle protected and don’t suffer from any stock market risk. And now, more often than not, you are being sold a RILA rather than a FA.
Again, these are not good reasons to own an annuity, but annuities are, for the most part, not intended to be stock-alternatives. Accumulation is not where annuities shine. They are bond-alternatives.
Bond-Replacement Features of Annuities
A Fixed Indexed Annuity might return 1-2% more than bonds over time. If you use a FIA instead of bonds and increase your equity exposure as a result, chances are you will come out ahead. This is a use case of annuities during accumulation. If you must have bonds, especially if you think about “income” rather than total return, an annuity might do you well.
I would much rather you think of total return investing, as investing for income is riskier. As you reach for yield in fixed-income products, you increase your risk by definition. Annuities actually decrease risk and can provide stable and/or more income during accumulation.
But during de-accumulation is when annuities as bond-alternatives shine.
When I Retire and an Annuity as a Bond-Replacement
Why do you have bonds when you retire?
Some folks think about bond ladders as providing liability matching assets. You need money in 2, 3, 4, and 5 years, so you set up bonds that mature in those durations. In today’s interest rate environment, bond ladders are dead.
An annuity is more efficient than bond ladders. Here, compared to a long bond ladder (you have ongoing liabilities you want to meet with an income stream), a SPIA is most efficient. A Single Premium Immediate Annuity removes a lump sum out of your portfolio and provides a long-term ongoing income stream. Bonds do not come close to a SPIA due to mortality credits. They just don’t.
For a shorter term bond ladder, a period certain annuity might be indicated. With any sort of return of premium guarantee or feature, you are losing out on mortality credits, but you might still be better off than bonds. Or, consider MYGAs. Rates are better with MYGAs than with bonds or CDs. And they are tax-deferred. If you plan to have an income stream anyway (via withdrawal or annuitization), MYGAs can make sense as a short term bond replacement.
I’m not a big fan of bond ladders because, again, the idea is that bond ladders provide income. They don’t in today’s world, and we must think about the purpose of bonds in a total return world, not an income portfolio world.
When I retire, the purpose of an annuity is to provide income as part of a total return approach.
When I Retire: Total Return and Annuities as Bond-Alternatives
So, in a total return world, what is the purpose of bonds? Bonds provide stability and a source of income if stocks just happen to be down when you need income.
Stability. When a 90/10 portfolio goes down by 40%, a 60/40 portfolio may only be down 25%. Remember, you have to gain back much more than 40% to recover from a 40% decline. It is easier to claw back from smaller declines. Plus, you can re-balance a bond-rich portfolio when it is down to “buy low” and then “sell high” when you need the income.
Do annuities provide stability? Yes, but in a different way.
You may suffer a more significant loss if you use annuities as bond-alternative and increase your equity exposure due to having an annuity. But when you retire, remember, annuities are for income. If you have a lower income need each month, you won’t have to sell equities when they are down because you don’t need the income. So, you lose out on the re-balancing with an annuity, but your portfolio is under less stress to provide an income as well.
There it is. As a bond-alternative, annuities provide higher income than you can get from bonds. When the market is up, you have less need for withdrawals. When the market is crashing, you still have income needs. Part of those needs are filled by the annuity income, and part is still from the smaller amount of bonds you have in your portfolio.
Do you understand why you might want to have an annuity when you retire? What is the purpose of the money?
Purpose of Annuities When I Retire
Too often, I come across folks who have annuities, and they don’t understand why. What was the purpose of the money you put in the annuity?
That is unfortunate, and it is driven by the fact that the annuity was sold and not purchased. It is the fault of the “advisor” who wanted the commission rather than to help. That is harsh, but please understand, annuities need to be purchased, not sold. You need to want an annuity, and to want one, you need to understand the purpose of the annuity.
So, during accumulation, you might want tax-deferral and growth with the possibility of a future income source. Tax-deferral implies you are already optimizing your other tax-deferred options. Be very careful about buying an annuity in an IRA or a 403b. Very careful.
What is the purpose of a tax-deferred vehicle in an already tax-deferred account? Growth: sure, you can use annuities as bond-alternatives during accumulation. Income: sure, you can annuitize the money where you get an income in exchange for the money. Also, there are riders (that cost money) that allow you to get an income without annuitization and giving up the lump sum. And there are other withdrawal features, return of premium, death benefit, long-term care…. And the list goes on and on into complexity. Complexity is the opposite of purpose, though. What is the purpose of the annuity during accumulation?
And, when I retire, what is the purpose of the annuity? Income is a good purpose. We all need income. After all, the function of retirement planning is to turn assets you have accumulated into income to live on after the paycheck stops.
For now, I’m going to stop there. Remember, you need to understand the purpose of an annuity in your overall plan. There are many reasons to own an annuity. Complexity is not one of them.
PROs and CONs of An Annuity When I Retire
I do not sell annuities. I don’t often even suggest them. But I firmly believe you need to buy one, not have one sold to you. Thus you need to understand the pros and cons to know when you might consider buying one.
Pros of an annuity when I retire
Let’s look at the top reasons to have an annuity:
Fees are worth the cost
Not all annuities are chock full of fees. Advisor-sold Variable Annuities seldom tend to be worth the cost. But Investment-Only Variable Annuities can be used to 1035 exchange prior bad decision annuities or life insurance into lower-cost alternatives to make up your basis before finally selling them.
In addition, no-load variable annuities with income riders might be considered if you want to use them as a sequence of return risk hedge. The strategy here: aggressively invest in a low-cost VA for retirement. If the market does great, you do fine. If the market doesn’t do well, you still have the guaranteed return you get from the income rider. Win-Win. Some suggest putting up to 30% of your nest egg in the VA Sequence Risk strategy. I don’t think I’d ever bite on this, but it is, in fact a use case for a VA. Blame Moshe Milvesky for the idea, not me!
Some annuities are “Free”
You will often hear that Fixed Indexed Annuities have no fees. While that is strictly true (100% of your money is put into the account—sometimes with a bonus!), the advisor is being paid from the spread on your illiquid money. That is, the insurance company earns more than they pay out, and there is a surrender penalty to get out of the annuity before the lock-up period. They use that spread to pay the salesman if you leave early. Let’s be honest, though. Nothing in life is free.
As a Bond-Alternative
Indexed Annuities pay more than bonds. That’s right. There is a use case for annuities as a bond-alternative. If you take some money out of your bonds and put it in an annuity, you might earn 1-2% more than if you leave it in bonds. Remember, bonds have a purpose in your portfolio and make sure you understand what that is. I’ll just say it now—bonds are no longer for income. Total return trumps income anyway, as I explained in the last blog.
Index Annuities are deferred annuities and protect against loss of principle. If you want return of your money more than return on your money, a MYGA or Fixed Indexed Annuity might be worth considering.
Enough said. If you are a high-income earner and max out your other tax-deferred space, this is at least worth considering. Tax-deferral is an indication for Life Insurance as well. Careful as there is a 10% penalty if you take out income before 59 and a half.
Income You Cannot Outlive
People who have annuity income are happier than people who don’t. Spend your account down to zero, and magically more money appears next month. That is a nice feeling! Of course, maximize social security before you consider this use of an annuity. Social Security is the best annuity around.
You Cannot Tolerate Market Volatility
If you understand that volatility is not risk and you don’t lose out unless you sell, then this is not a problem. But people sell low all the time. They would be better off if they didn’t invest in the first place! For these troubled people, an annuity might help. If you cannot help yourself and you will sell low, don’t invest in the stock market; look to a VA or FIA.
I’m going to say that again: Mortality Credits. Understand these if you are going to buy an annuity.
If you are worried about outliving your savings, an annuity is right for you. Your bond portfolio will not provide you with as good of an income floor as an annuity because of mortality credits. Mortality credits mean that the annuity company can pay your more from day one because they know some people will die and stop being a liability on their balance sheet. This “risk pooling” allows them to pay you more. Many complex features of annuities (such as period certain and return of premium) destroy mortality credits and much of the reason behind getting an annuity in the first place.
You cannot beat the fixed-income returns of an insurance company. They are big and get better prices on bonds and hold them for the duration. If you want income, think no further than a SPIA
Insurance Companies—They Play Both Sides of Life
If you die early- they win because they stop paying out your annuity. And if you die late- they win because they can wait to pay out on your life insurance. If an insurance company has too much liability from life insurance, they can sell annuities and visa-versa. Die early or die late; they are covered. For the most part, insurance companies are highly rated and secure companies that will not go out of business. If they do, there are funds in your State to cover some of your losses.
You Blow All Your Money Every Month
If you cannot save, you might want to think about an annuity. After all, once you turn on the income stream, you can spend everything you get, and next month there will be more. But then again, if you blow all your money, how did you save up enough for an annuity in the first place?
This might be oversold, but not infrequently, annuities have better creditor protection than your brokerage account. This is state-specific, so see here.
You have under-saved for retirement
Honestly, if you take your cash out and buy a SPIA, you will be better off if you plan to live a normal or prolonged life span. Mortality credits will pay you better than your bonds do.
You think you need an income-producing portfolio, so you are taking too much risk
Risk can sneak up on you in all sorts of ways if you reach for yield. If you are reaching for yield, annuitize some of your reach, and you will reduce risk significantly. Total return investing beats the pants off of income production for this generation. If you need income-producing assets to retire on, think again, and think about a SPIA instead.
You have longevity
You are already old but desperately need to do Roth conversions
Yes, you can still do partial Roth conversions when older than 72. A QLAC or two might help out in this situation. If you take longevity out of the equation by using a QLAC or two, you might be able to save your heirs a ton of money, especially if they are in a high-income tax bracket or you must put your legacy assets in a trust. This is a new idea I just had. I’m not sure how well it would work out, but it is a consideration if you want longevity insurance and the ability to aggressively Roth convert after RMD age.
You desperately want Long-Term Care Insurance but cannot get it with traditional or hybrid policies
Annuities with Long-Term Care riders tend to be based on your mortality risk rather than your morbidity risk, whereas the opposite is true with hybrid Life Insurance/LTCI policies. We are getting far into the weeds here, but if you have a pot of money lying around and you desperately want LTCI and cannot get it through other means, talk to a salesperson about an annuity with an LTC rider.
You must have guaranteed income for life
The safety-first vs. investment-only spectrum is just that—a spectrum. I suppose some people cannot take any risk at all and cannot have any stock market risk.
Cons of an Annuity When I Retire
- Because you got sold one.
- You don’t know the purpose of the money.
- You don’t understand every feature and bell and whistle attached to the product
- The money is already tax-deferred. Don’t get snookered into investing your pre-tax money into an annuity. This is called a qualified annuity. One of the nice features of annuities is tax deferral. If you are investing in an already tax-deferred account, please be careful!
- You know how to invest your money and are comfortable with volatility. If so, a total return approach will beat out an annuity. Only if you use an annuity as a bond-alternative might you win. If you are thinking about an old-fashioned bond ladder just stop it—and get an SPIA instead
- Your Gut Tells You No. Just Walk Away if your gut tells you no. There is almost no reason why you cannot buy an annuity tomorrow instead of today. If considering a deferred product, the longer you wait the less you might make. Eventually, you will lose out to inflation, but not in just one day. Remember, you buy annuities, you are not sold them.
Summary: Should I buy an annuity when I retire?
Honestly, if you can think of any possible bad feature of an annuity, the industry can come up with a comeback for you. A lot of the complexity baked into annuities are “answers” to people’s problem. Here are some of the problems:
They are Illiquid—so FIAs and VAs have withdrawal features that allow you to take out 10% or so a year
Loss of Legacy—they make return of premium riders and death benefit riders for these. I’m not sure these will ever make sense because if you plan to die early, an annuity is seldom right for you. If you plan on living a long time, then you will be happy if you die early, and the kids can have whatever is leftover.
Loss of Money—there are period certain annuities that pay you or your heir for a certain period of time. These mostly don’t make sense unless you are using them to cover expenses until some other income source kicks in. Again, this takes away mortality credits which is what makes simple annuities so special.
I like to keep it simple. If you want income, if you understand mortality credits, and if you want a safety-first retirement, then consider an annuity.
Remember, in times of low-interest rates, mortality credits actually payout proportionally more than during times of high-interest rates. So, bonds won’t do what annuities can do when rates are low.
When I retire, I am going to have an annuity. It makes a lot of sense to have some income coming in every month. Should you have an annuity when you retire? If you don’t have a pension and want to live longer and spend more, then the answer is yes!