Retirement Investing Choices: Annuities

This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top. 

Now that we’ve discussed how much you need to save for retirement and provided some information on mutual funds and ETFs, we can start to discuss some of the different investment options for your retirement portfolio and their role in the big picture of things.  Today we’ll start with an asset called an annuity.

An annuity is an income vehicle issued by an insurance company.  In exchange for turning over some of your money to the insurance company, they agree (guarantee) to pay you a specified amount of money for a specified period of time, which could be the rest of your life.  Because annuities are insurance contracts, there are all sorts of different types, limited only by the insurance company’s creativity in designing a product they hope they’ll buy.

The main benefit of an annuity is the guaranteed income.  That guarantee comes at a price, however, in that the income you receive will be less than the income your money could have generated if you had invested it on your own.  They should therefore be used when security is more important than return, or if you simply don’t want to fool with things and are willing to accept less in exchange for your time and effort.  Annuities are a fix-it-and-forget-it type of investment.

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The most basic type of annuity, called an immediate annuity, simply pays you a specified amount of money starting immediately for a prescribed period of time, often the rest of your life.  For example, let’s say that you buy an immediate annuity at age 70, giving the insurance company $1 M.  They may in exchange give you $4,166 per month, or $50,000 per year, for the rest of your life.  If you live to age 90, you would then have collected $1 M back from from the policy.  If you live to age 100, you’ll have collected  $1.5M.

All policies are different, so you should read the terms carefully, but many policies would simply keep your original $1 M investment when you died.  So if you die at age 71, you would have only receive $50,000 back from the insurance company for the $1 M you gave them.  They would make out very well on the policy.  This makes up for the people who live to age 100, and is the nature of insurance – they make lots of money from some policies to make up for the others where they lose money.  Some policies might reimburse your heirs a portion of the investment if you die before a certain age, but this is not a certainty.  Again, the are contracts between you and the insrance company and can all be different, so you should carefully read and understand the terms (and maybe have an attorney or CPA read the policy as well) before you buy anything.


Another popular type of annuity doesn’t pay right away, but instead starts to pay when you reach a specified age in the future.  These are useful if you’re worried about running out of money later in life.  For example, at age 50 you could buy a policy that starts to pay you a monthly amount at age 80.  The earlier you buy these policies, the less they cost for a given pay-out (since you’re taking a chance that you’ll never reach that age, plus you’re letting the insurance company use your money for all of those years).  These can be a very useful way to guarantee that you won’t be destitute should you live a long time.  They are also relatively inexpensive since there is a real possibility the insurance company may get to keep the money and never pay out anything.  The later in life the policy starts pa, the less it should cost.

While there are limited exceptions (insurance companies spend a lot of money doing calculations and making sure that they come out ahead), on average you’ll not do as well with an annuity as you would have had you invested on your own.  While you might be taking some of the insurance company’s money if you live to age 100, most people will not live past 85 or 90.  Taking the same example of a $1 M nest egg described above, if you had invested the money instead of buying an immediate annuity, a properly designed portfolio of stocks and bonds should allow you to withdraw about $30,000 – 40,000 per year for the rest of your life, indexed for inflation, without ever touching the principle.  This means you could have withdrawn about $1,050,000 between the ages of 70 and 90 and still have had $1.6 M to leave to your kids when you died.  This is compared to receiving $1 M from the annuity and having nothing to leave your kids.

If you lived to age 100, you’d have withdrawn about $1.8 M from the portfolio, versus receiving $1.5 M from the annuity, and now have $2 M to leave to your kids (which will buy what $1 M buys today).  Investing on your own, instead of buying an annuity, will generally result in you both receiving more income while you are alive and in you having more money to pass on to your kids.

So, with an annuity, you’re trading risk – the risk that you won’t invest well or that the markets just won’t cooperate – in exchange for giving up some return on your money.  The insurance company now takes on this risk and needs to find ways to invest the money to ensure that they have enough money to pay the policy holders while still making a reasonable profit.  They set their pay-outs in such a way to make sure that they cover this risk, on average, just like how set their car insurance rates high enough to cover claims and still make money.  The amount they pay is also generally fixed (for example, $50,000 per year), so your spending power will decrease over time due to inflation.

You may worry that an insurance company may charge you way too much for an annuity, resulting in a huge profit for them, but market forces should generally take care of this for you as long as you do your part and compare products from several different providers to get the best deal.  As long there are enough insurance companies out there competing for your business, you should get the maximum return possible with the insurance company making just enough money on your policy to pay the person who sold it to you, keep the lights on, and make a reasonable profit for their shareholders.  You’ll still be paying for all of this overhead, but that is what you are trading for the security of a monthly payment instead of the less unpredictable returns from an investment portfolio.  Just make sure you do your part and shop around for the best return, since once you buy in it is expensive to undo the deal, even when you can.

Realize also that people selling annuities to you generally make a commission from the sale, which both adds to the cost and makes them eager to sell you something, even if it isn’t the best thing for you.  Many of these salesmen know little about what they’re selling.  They just know what they’ve been told to tell you to get you to buy.  In general the choice to buy an annuity should be yours, not the result of a high-pressure sale, and you should take the time to read the policy and review it with whatever professionals you need to make sure you’re making a good decision.

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Some annuities also make offers of additional potential returns based on the stock market or come with other bells and whistles. While this may sound enticing, you’ll do better just buying a smaller annuity and investing the rest of the money yourself.  Remember that the insurance company needs to make money, so the returns they’ll provide will be well lower than market returns.  Only buy annuities when you want a guaranteed return, not as a way to invest in the stock market.

Finally, know that the guaranteed return from an annuity is only as good as the insurance company who you buy the policy with (and whomever they sell it to).  If we see another Great Depression, it is very likely that the insurance companies would all go broke and leave policy holders in the lurch.  Because they need to invest the money in the markets themselves, if most businesses are going bankrupt, they would not have the money to pay out the payments each year in a collapsing market.  Note that the supposed “great recession” was nothing like the Great Depression.  Luckily such market events happen fairly rarely.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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