Why I don’t Hate Annuities
Annuities have one of the worst reputations in financial services, and sometimes deservedly so. But there are many types of annuities, and some can serve the purpose of tax deferral or lifetime income. Today we’ll focus on lifetime income. Annuities may not be the right solution for some people, but they might be intriguing for those who feel uncomfortable with market volatility and are concerned about outliving their assets.
As a fee-only advisor, I don’t receive commissions or compensation from insurance companies or annuity providers. My role is not to sell products, but to evaluate whether a particular tool improves a client’s overall plan. Many times an annuity is not necessary, but in certain situations it can meaningfully reduce specific retirement risks.
Annuities are an insurance product, and insurance at its core is a risk transfer strategy. You are transferring some risk to an insurance company. With life insurance, you are transferring the risk that you will die early, before having the chance to earn, save, and grow your wealth. Annuities with income benefits transfer the risk that you will live a long life and outlive your financial assets.
Many clients that were excellent savers struggle to spend in retirement, because the same habits that made them great savers make them afraid to spend in retirement. Additionally, it is difficult to know the truly safe withdrawal rate from a portfolio of investments. The safe withdrawal rate depends on future returns, volatility, and time horizon, none of which are knowable in advance. Annuities can shift part of these risks to an insurance company in exchange for reduced flexibility and potential upside.
Three of the most important variables in creating a retirement plan are future returns, volatility, and longevity. Even if you knew the average return for the rest of your life, you could not know for sure how much you could spend due to sequence of return risk. When you have a lump sum of money invested and you neither add to it or take from it, the sequence of returns doesn’t matter, the end result will be the same. But when you are taking regular withdrawals from the portfolio, the sequence of returns does change the end result. The 4% heuristic that many advisors use is based on research by Bill Bengen that uncovered this sequence of returns risk. Having mediocre or poor returns early in retirement has an outsized impact on the outcome of the plan compared to later in retirement.
When you’re creating a plan for one or two individuals, you plan for more extreme scenarios such as worse returns, higher volatility, or a longer time horizon. You only have one retirement, of course, so you want to be fairly certain you’ll be ok. The insurance company utilizes the law of large numbers. Predicting the longevity of one person is impossible, but the average longevity of thousands of people, all over the country, is more consistent. The insurance company can pool longevity risk across many policyholders, allowing predictable lifetime payments. The actual distribution rate depends on the type of annuity, your age at issue and the age you begin income, and interest rates. It is important to note the the income or distributions are not typically tied to inflation, and may remain flat over time. Inflation is a significant risk in retirement, which has to be considered in a plan. That said, other assets such as stocks and social security benefits may address the inflation risk where the annuity does not. Additionally, there is a balance between being able to spend more early in retirement when you are more likely to be healthy and active versus later in retirement, ignoring long-term care risk for this piece.
It’s important to emphasize that an annuity is not inherently better than a diversified investment portfolio, nor is it a replacement for thoughtful planning. In many cases, maintaining flexibility, liquidity, and long-term growth potential through traditional investments will remain the better choice. The role of an annuity for retirement income is helping address a specific risk rather than serving as the foundation of a retirement strategy.
Annuities are often viewed as either entirely good or entirely bad. In reality, they are neither. They are insurance, a way to exchange uncertainty for predictability.
Good retirement planning is not about eliminating risk, because that isn’t possible. It is about deciding which risks you are willing to live with and which risks you would rather insure against. For some investors, market volatility is manageable but longevity uncertainty is not. In those cases, an annuity may play a thoughtful and limited role within a broader plan.
This content is for educational purposes only and does not constitute investment advice. Past performance is not indicative of future results.