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 actually like annuities and what they can do for you. People live longer when they have an annuity. Maybe it is because they want to beat the actuarial assumptions of life span, or maybe it is the never-ending stream of income that comes in every month. There is a lot to be said for annuities. And against.
But stocks 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.
Stocks 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. Stocks can’t do what annuities do because they are not supposed to! And in fact, most of the time, annuities are actually bond-replacements rather than stock-replacements.
Stocks have their place in your portfolio. They are to grow, outpace inflation, and provide you with total returns (which is your income when retired). Bond are there to 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. First, let’s look at the aspects that are stock-like and those that are bond-like.
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. It is not, for the most part, if you plan to own stocks for 10-15 years. They will almost always out perform most other instruments over that time span. The risk is in NOT owning stocks and having your money loose 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. Or, consider a Fixed Indexed Annuity (FIA), as they are principle protected and don’t suffer from any stock market risk.
Again, these are not good reason to own an annuity, but annuities are for the most part not intended to be stock-replacements. Accumulation is not where annuities shine. They are bond-replacements.
Bond-Replacement Features of Annuities
As bond-replacements, annuities can shine! Even during accumulation.
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 are thinking 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, by definition you increase your risk. Annuities actually decrease risk and can provide stable and/or more income during accumulation.
But during de-accumulation, it is when annuities as bond-replacements shine.
De-Accumulation and An Annuity as a Bond-Replacement
Why do you have bonds during de-accumulation?
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 a 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 takes a lump sum of your money out of your portfolio and instead provides you with a long-term ongoing stream of income. 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. There is tax deferral. If your plan is to have an income stream anyway, MYGAs might make sense as a short term bond replacement.
I’m not a big fan of bond ladders because, again, they idea is that bond ladders provide income. They don’t in todays world, and we must thing about the purpose of bonds in a total return world, not an income portfolio world.
In de-accumulation, the purpose of an annuity is to provide income as part of a total return approach.
De-Accumulation, Total Return, and Annuities as Bond-Replacements
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 in order to “buy low” and then “sell high” when you need the income.
Do annuities provide stability? Yes, but in a different way.
You may actually suffer a larger loss if you use annuities as bond replacements and increase your equity exposure as a result of having an annuity. But during de-accumulation, 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-replacement, annuities provide income that is higher than you can get from bonds. When the market is high, 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.
As a bond-replacement, annuities don’t replace all bonds, just some.
Anyway, we are getting thick in the weeds here, and I’m sure I have lost many of you. Let’s get back to something a little bit easier to comprehend and see if we can tie it together with the idea of annuities as bond-replacements during de-accumulation in a total return world. Back to purpose.
Do you understand why you might want to have an annuity? What is the purpose of the money?
Purpose of Money in Annuities
Too often I come across folks who have annuities and they don’t understand the purpose of the money. 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 in order 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-replacements 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, during de-accumulation, 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 pay check stops.
For now, I’m going to stop there. Just 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.
What is the Purpose of That Annuity?
So, what IS the purpose of that annuity?
Why do you have money for anything? What purpose does that pot of money serve?
Remember, accumulation is different than de-accumulation. Annuities are not stock-replacements, but rather bond-replacements.
Make sure you know what the purpose of that annuity is before you buy. And remember, there are actually “good” annuities out there, too.