Annuities are an underutilized tool in retirement planning—according recent academic research. The value of an annuity is that you receive a steady stream of income for the rest of your life, and in certain instances the cash received will exceed the amount that can be safely drawn from a portfolio. In those instances, investing in annuities can allow someone to increase spending without increasing the risk of running out of money during retirement.
The resistance to annuities is due to a couple of primary factors. First, many financial advisors are compensated as a percentage of asset-under-management and their focus is on portfolio growth. Liquidating a substantial portion of the portfolio to purchase an annuity is not generally something they even consider. The second reason is that the insurance industry over the years has introduced complex annuity products with very high fees sold by non-fiduciary advisors that in many cases are not in the best interest of clients. This has left a stigma on the product.
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. There are two phases to an annuity transaction: (1) accumulating the lump sum and (2) converting the lump sum into a stream of payments (called annuitizing). The value that insurance companies add in the annuitization phase is that they pool your funds with other annuitants, thereby spreading the risk. Those who die early subsidize those who live long, and everyone is assured an income that they will not outlive.
One of the issues with annuities is that insurance companies found that there was a lot of profit to be had in the first phase of an annuity transaction (accumulating the lump sum). The problem is that insurance companies are generally not able to add any value during that phase. Insurance companies are required by law to invest most of their assets in bonds, so an investor with a diversified portfolio of stocks and bonds would almost always earn a greater return and thus accumulate a greater sum to later convert into a stream of income. The solution the insurance industry came up with was variable annuities, in which separate accounts were created for the investor to invest in stock mutual funds. But these accounts almost always have such high fees that you would be better off investing in your own portfolio of low cost index funds to create the pool of assets.
My view is that it only makes sense to purchase immediate income annuities with a guaranteed income stream that starts right away or within a few years. However, I have not seen many cases with my clients where it made sense to do this until they were in their mid-seventies. With a very long payout period, the value generated by pooling your risk with others is offset by the lower bond market returns that determine the payouts insurance companies are able to offer. Part of this is due to the current low interest rate environment we are in. If interest rates begin to rise, annuities may become more attractive to purchase at younger ages but as of today generally only make sense for folks to consider only when they are well into retirement.
Feel free to reach out if you have any questions.