Annuities in Retirement
What is the purpose of that money in retirement? When you buy an annuity, you trade a lump sum to access a risk pool. You pool your risk with others to mitigate the risk. You don’t invest in annuities; you buy insurance!
Annuities can do quite a lot. Quite too much most of the time! My new favorite saying is that 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 discuss what that means and try to understand the purpose of the 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, 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 (your retirement income). 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! Moreover, they are often too complicated.
Keeping things simple, though, let’s break down and review some features of annuities when you 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. Mostly, 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 think it is risky, then perhaps there is a role for an annuity. Here, you can consider a variable annuity (VA), which invests in actual stocks within an annuity wrapper. This is not an efficient way to gain exposure to the equity market. However, 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 for the most part, annuities are not intended to be stock-alternatives. Accumulation is not where annuities shine. They are bond-alternatives.
Bond-Replacement Features of Annuities
As bond-alternatives, annuities can shine!
A fixed-indexed annuity might return 1-2% more than bonds over time. You will likely come out ahead if you use a FIA instead of bonds and increase your equity exposure. 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 consider 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 decrease risk and can provide stability and more income in retirement.
But during de-accumulation, annuities as bond alternatives shine.
When I Retire: Replace Bonds with an Annuity
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.
An annuity is more efficient than bond ladders. A SPIA is the most efficient. A Single Premium Immediate Annuity removes a lump sum from your bond allocation and provides a long-term ongoing income stream. Bonds do not come close to a SPIA due to mortality credits.
For a shorter-term bond ladder, a period certain annuity might be indicated. With any 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.
When I retire, the purpose of an annuity is to provide income as part of a total return approach.
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 when you need income if stocks are down.
Stability. When a 90/10 portfolio drops by 40%, a 60/40 portfolio may only be down 25%. Remember, you must regain 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 that 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 also under less stress to provide an income.
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. The annuity income fills part of those needs, and part is still from your smaller bond allocation in your portfolio.
As a bond-alternative, annuities don’t replace all bonds, just some.
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 annuity was sold by the “advisor” who wanted the commission. Annuities must be purchased, not sold. You need to want an annuity, and to want one, you need to understand the purpose of the annuity. What is the purpose of the money you put in an annuity?
During accumulation, you might want tax deferral and growth with the possibility of a future income stream. Be careful about buying an annuity in an IRA or a 403b.
Reasons to use as bond-alternatives during accumulation. Income: sure, you can annuitize the money where you get an income in exchange for the money. Also, some riders (that cost money) 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 turning assets 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.
