In my opinion, the answer to the question “Do Annuities Ever Make Sense in a Retirement Portfolio?” is “Yes – In Certain Situations.”
In its simplest form an annuity is a contract between an individual and an insurance company. The individual gives the insurance company a lump sum of cash and the insurance company agrees to provide a fixed stream of payments to the individual for the rest of their life. Whether that contract ends up being a good “investment” for the individual depends on how long they live. Those who die sooner than the average life expectancy collect fewer payments and earn a “low return”. Those who die later than the average life expectancy collect more payments and earn a “high return”. In effect, those who die earlier subsidize those who live longer but everyone is assured an income that they will not outlive.
Over time, the insurance industry found that the market for these straightforward annuities was limited and began to create versions that have become both increasingly complex and increasingly profitable for the insurers. They have also fine-tuned their pitches to prey on the fears of investors. These are the annuities to avoid.
One example is the tax deferred variable annuity with income guarantees. The insurance industry is aggressively pushing individuals to rollover their 401k and 403b retirement assets into these types of annuities, promising stock market-like returns, with protection in case of a market downturn. The pitch sounds very appealing. One that I analyzed for a client appeared to guarantee a 6% return on the assets being rolled over. It seemed too good to be true, and of course, it was too good to be true. The 6% in this case did not reflect a return on the portfolio but rather the annual increase in the annuity payment for each year that passed.
For comparison purposes, consider that the payment you receive from Social Security (which is also an annuity) increases by approximately 8% for each year that you wait before starting to collect (since you will be receiving payments for one less year). If you look at it that way, a 6% increase doesn’t seem so great. For this particular annuity, the incremental fees that my client would have paid over thirty years, when compared to simply investing the portfolio in low cost index funds, would have amounted to almost $450,000. This was on an initial investment of $700,000. There was some value in terms of the guarantees to protect against a severe market downturn but there are much less expensive ways to manage the risk of stock market volatility.
These products are also incredibly complex. In the example above it literally took me hours to do all the math to understand exactly how this particular contract worked under different market return scenarios. I would question how many “advisors” selling a product like this truly understand the specifics of these contracts. But what they do understand is the commission. A commission on a product like this might be 7%, which in this case would have meant a $49,000 commission for the advisor. It is no coincidence that the first year surrender charge (the fee you pay to cancel the contract) is often 7%, which essentially allows the insurance company to recoup the commission paid to the advisor.
So when do annuities make sense? One example would be someone who would like to spend down their retirement portfolio faster than a safe withdrawal rate would allow, and is not particularly interested in leaving a big legacy for their heirs. What that individual could do is purchase at age 65 a deferred annuity that starts paying out at age 85. This annuity income (starting at age 85) combined with Social Security would provide an acceptable level of income from that point forward. Since the insurance company has twenty years to invest the money and the life expectancy past age 85 would be short, the cost of the annuity would be relatively low. The investor could then draw down the remainder of their retirement portfolio more aggressively since the portfolio now only has to last a defined twenty years. If the investor dies before age 85 the investment in the annuity would be lost but since leaving a legacy is not a priority, this should not be an issue.
Another situation where an annuity might make sense is for someone who was not able to accumulate a significant retirement portfolio and the amount that could be safely withdrawn and still ensure that the portfolio lasts into their 90’s is too small to make a meaningful impact on their lifestyle. In that case, the best approach may be to use the bulk of their retirement portfolio to purchase an annuity. This income, along with Social Security, is what that individual will have to live on for the rest of their life. It may be a way to make the best of a bad situation.
A third situation where an annuity may make sense is for someone who has maxed out all their taxed deferred savings vehicles (401k, 403b, IRA’s, etc.). In this case, an annuity may be a way to gain additional tax deferral. An investment in a whole life or universal life policy may also make sense in that situation.
As always, feel free to reach out if you have any questions. Enjoy the holiday!