Is an Annuity Right for Part of Your Retirement Funding?

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.  The posts will appear in reverse order, with the newest post first. 

I have recently gained a new appreciation for annuities, or at least the promise that an annuity holds.  At one point I swore off annuities entirely and there are good reasons to do so.  These include:

  1. You can do better investing the money yourself.
  2. The fees can be high.
  3. You generally have little flexibility once you have made the purchase, and may need to pay a big fee to receive any of the money back.

But then I realized the true purpose of an annuity is the same as it is for any insurance product:

To shift your risk to the insurance company in exchange for the cost paid.

All annuities pay you a specified amount of money for a specified period of time in exchange for you handing over a load of money to the insurance company.  For example, you give them $100,000 and they agree to pay you $500 per month for the rest of your life.  In many ways this is like a pension plan where you receive payments, except this is from an insurance company instead of an employer.  In fact, many employers that still have pension plans use annuities to make the payments once individuals retire so that they don’t need to worry about it.  They just buy an annuity that pays the former employee whatever is needed when they retire and then the employer’s part is done.  You can create your own pension using an annuity if you commit your 401k funds or other retirement savings.

Now while there are probably as many different kinds of annuities as there are stars in the sky, since they are all just insurance polices and the types are only limited by the imagination of the companies that create them, there are really only two types of annuities that should hold any interest for you.  These are immediate annuities and deferred annuities.  And here we just want the plain vanilla types – no bells and whistles.

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Immediate annuities are just that – you give them money and they immediately start making payments to you.  These are used to provide regular income without needing to worry about what the markets are doing, buying and selling mutual funds, or performing other actions.  Deferred annuities pay after you reach some certain date, for example, starting to pay you $5,000 per month after you reach age 85.  These are used as insurance against outliving your money.

So why are annuities not as good as investing yourself, in general?  The reason is both that they charge fees (which can be big) and the return you get from an annuity, including fees, will not be as great as you would get if you had invested yourself.  For example, if you were to invest $1 M at age 65 in a balanced stock and bond portfolio, you would be able to receive about $40,000 per year, indexed for inflation, until you were age 95.  At that point you would have on average about $2 M in the account and have received about $1.8 M in payments during that time.  The $2 M would be able to buy about what $1 M can buy today, so you would effectively have all of the money you started with, plus have received an income to fund a $40,000 (in year 2018 dollars) per year lifestyle.

If instead you were to put the money into an immediate annuity, you might start getting paid about $75,000 per year, fixed.  If you then died at age 95, you would have received about $2.25 M during that period.  This sounds better than the $1.8 M you received from the investment portfolio, but the insurance company would keep the money you gave them when you died, leaving nothing for you to pass on to your heirs or from which to pay for your final expenses.  You would have gotten $450,000 less in income from investing, but would have $2 M in savings remaining instead of nothing.  Because an account can withstand about a 4% withdrawal rate without declining in value over time, spending at this rate can be done essentially forever, assuming no black swan market event occurs.

In addition, while you would start out better with the annuity, receiving $75,000 per year instead of $40,000 per year from the investment account, by the time you were 95 you would be receiving about $80,000 per year from the investment account where you would only be receiving $75,000 per year from the annuity.  While your spending power would start out greater with the annuity, the payments from the investing account would pass it up along the way and you’d be having a little more trouble meeting expenses with the annuity near the end.

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So why would you want to have an annuity instead of just investing yourself?  The beauty of the annuity is that you would (nearly) eliminate the risk of a market drop affecting your income.  Annuities also help protect you in the case that you live longer than average since many of them pay income until you die.  In fact, you’ll be able to utilize more of your money while you are alive using an annuity than you would investing yourself because, while you would need to limit your withdrawals to make sure you didn’t run out of money before you die if you’re investing yourself, the insurance company knows that if they sell 10,000 annuities, the average age at which people will die and distribution of ages is predictable and they can determine with a fair amount of certainty how much they’ll need to pay out.  They are therefore able to provide a higher payout per month than they could if they were just insuring a single person who might live to be 115.  If they know from historic data that the average person would live to age 84, for example, and how many people will live longer, they can determine the maximum payout they can make and not lose money.

Note that if you die young, say at age 66 when you buy the annuity at age 65, the insurance company would probably keep your whole $1 M.  This makes up for the people who live to be 100 and withdrawal more than the insurance company can make from their investment.  This is the nature if insurance – some people pay for more than they use to make up for those who pay for less than they use.     

And therein lies the reason that some people would want to use an annuity and others should invest for themselves.  If you are interested in leaving a lot of money to your kids or a favorite cause and you have enough money saved to allow you to generate enough income for expenses using 3-4% of the value of your savings each year, invest yourself.  If you don’t want to leave money, yet you don’t want to risk running out of money either, use an annuity.  You could also do a little of both, using an annuity for a portion of your savings to gain the additional income, but keep some invested in stocks to provide growth to allow you to increase your income should you live a long time and inflation starts really affecting the buying power of your annuity payments.

As far as what an annuity can and should pay you. realize that the insurance company will invest the money, probably mostly in common stocks if they don’t use the money to underwrite other insurance policies,.  The most they could pay would therefore be equal to the withdrawal rate they could make for the average life expectancy and have the money last.  As an example, if a person who is 65 buys and $1 M annuity and the insurance company figures out that the average person in the buyers risk-pool is likely to live 30 years, they could pay about $5368 per month or $64,418 per year if they were able to make an annualized rate-of-return of 5%, or about $7337 per month or $88,050 per year if they were able to make an annualized rate-of-return of 8%.

The amount they would offer would be somewhat less than this since they would take a fee off-the-top to pay the person selling you the policy, plus the insurance company would want to make a profit from the policy to make it worth their time, plus they may want to pay a bit lower than they would expect to make in case the markets don’t perform well during the period and don’t return as much as they were expecting.  They might therefore offer you $4500 per month if they were expecting to make 5% instead of the $5368 per month that they were expecting to make investing the money.  If there is ample competition (and you should shop around to make sure you get the maximum pay-out you can while still using a solid provider), you should get a reasonable return and their profit should be reasonable for the risk they are taking and their costs.

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Annuities are also a great choice if you have not saved as much as you really should have.  For example, if you have only saved up $250,000 by retirement, plus you have a home worth $500,000, you could maybe downsize or move to a lower-cost area and pull $350,000 out of your home.  (You could also possibly use a reverse-mortgage if you wanted to stay in your home, but again you would be paying a lot of fees in doing so.)  You could then take the $600,000 you had available and maybe buy an annuity paying $3,000 per month, or $36,000 per year.  Combined with Social Security, you should be able to make it through, although it might get tight if you live a long time after retirement.  You should therefore work as long as you can and build up all that you are able before you retire.  This will both increase your possible pay-out and reduce the number of years you’ll be in retirement.

But what if you want to have a good chance of spending most of your money, but want to get a better return that you will from an annuity?  If you have saved enough to fund your monthly expenses from investment returns, there is a way that you can invest yourself and still use more of your money than you will if you limit yourself to a 3-4% withdrawal, yet still have a low chance you will outlive your money.  The secret is to start out conservative, but then increase your withdrawal rate as you go.

For example, if you had $1 M and retired when you were 65, you would start out at 4%, or $40,000 per year.  At this rate there is a good chance your portfolio value will not drop at all (in inflation-adjusted terms).  If you wanted to be even more conservative, you could limit yourself to 3%.  After five years, at age 70, you could start spending at a rate that would exhaust your savings in 30 years, assuming some reasonable rate-of-return.  For example, as shown before, a 5% rate-of-return would result in a yearly payment of $64,418 as shown before.  Because your chances of living to 100 are fairly low (depending on the ages of your parents when they died, your current health, and other factors), you are fairly safe increasing your spending and starting to spend down your savings at this rate.

If you are still worried, you could also take some of the money and buy a deferred annuity that kicks in at age 90 or something.  Since it is unlikely that the insurance  company would expect you to receive many (or any) payments from this policy, the amount you would need to contribute to receive enough income for expenses at age 90 and beyond would be fairly low.  Plus, your expenses at age 90 if you live that long will likely be fairly modest.

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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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