When I’m asked if annuities are a good purchase, I say it depends on everyone’s own situation and goals.
Historically, I have not been a big fan of variable annuities as they have often been a black box of high fees and even though I’ve been reading about better low-cost options recently, these are still not something we really deal with at my firm.
Income annuities and fixed-indexed annuities, however, can have a place in retirement portfolios by replacing the fixed-income or bond-like holdings in retirement portfolios in some instances.
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With interest rates rising over the past couple of years and thus causing bond and fixed income investments to decline in value, many clients and prospective clients have asked about annuities.
Today I am reviewing a great article from retirement spending guru Wade Pfau on how guaranteed annuities are better than bonds for retirees.
The article is called The Fundamental Logic of Annuities with Lifetime Income.
Balancing Risks and Returns
When it comes to investing, we want to balance the risks with the potential rewards.
When planning for an indefinite time, like your retirement, there are several types of risk to consider, but I’ll focus on just a few here.
- Investment risk is the possibility that an investment won’t produce a desired return.
- Sequence of returns risk is the possibility of receiving lower or negative market returns during the beginning of your retirement when you start withdrawing funds.
- Longevity risk is the possibility of outliving your investments.
When it comes to retirement savings, there are 3 main ways to invest your nest egg: stocks, fixed income (bond type investments), and income annuities.
- Stocks generally have the highest potential for growth, but also the highest risk due to their volatility.
- Fixed Income (bonds) generally have a lower potential for growth, but they are generally less volatile and provide stability to a portfolio.
- Income annuities also provide stability to a portfolio, and they can allow for higher income payments throughout retirement.
How Does an Income Annuity Work?
A basic, life-only income annuity is essentially an insurance policy that effectively manages longevity risk by pooling the risk of a large group of people.
Insurance companies use actuarial tables to estimate longevity patterns among the group. Those with shorter retirements leave money on the table to subsidize those who live longer.
In this way, an income annuity is similar to a defined-benefit pension plan.
Thanks to that pooled risk, an income annuity can support a higher level of spending for all annuity owners than a bond portfolio can on its own.
Pfau says “Bond funds are volatile, exposing retirees to potential losses and sequence risk while still not providing enough upside potential to support a particularly high level of spending over a long retirement.”
A fixed income annuity can effectively replace the bond or fixed income portion (or War chest as we call it at my firm) of holdings in a retirement portfolio that are set aside to meet ongoing spending.
Annuities pay roughly the same return, are less volatile, and Pfau says we should regard them as a type of coupon bond which provides payments for an uncertain length of time (lifetime), in which the principal value is not repaid upon death.
An Income Annuity Isn’t for Everyone
In hindsight, if a person experiences a short retirement or retires during a time with strong market returns, they may have been better off not purchasing an income annuity.
But this isn’t something you can predict, and an annuity is a form of insurance against the unknown.
The same could be said about paying for car insurance for years or decades when you have never had an accident or filed a claim. You still pay for car insurance to manage the unknown.
However, someone who experiences a long retirement or retires during a market downturn would benefit from the additional spending that is allowed by having an income annuity with its pooled risk.
An income annuity provides insurance against outliving assets (longevity risk) and insufficient income late in retirement (sequence of returns risk).
When building plans for clients, we look at guaranteed income sources, such as Social Security and pensions. Then we consider if an additional guaranteed source of income would be beneficial to meet their retirement goals.
Let me give you an example: Let's say you have a $1,000,000 nest egg, you want $100,000 to spend annually, you have $40,000 coming from Social Security, and we want to get your guaranteed income up to 50-70% of your annual spending.
If your Investment Policy Statement says you should be invested in a 70/30 split between stocks to bonds (or fixed income), that means you have $300,000 in your "war chest," and we could use a portion of that to buy a fixed indexed annuity to bump up your annual guaranteed income into that 50-70% range.
Many retirees have enough guaranteed income from other sources plus enough other money saved up so that they don’t need the additional guarantee of an income annuity.
Annuities With a Death Benefit
Pfau’s article focuses on income annuities with no death benefit.
However, some fixed-indexed annuities are structured to allow for a death benefit if your retirement ends sooner than expected, such as within 15 years or another pre-determined time frame.
So, this type of annuity would have more benefits than what he discusses in his article.
Retirees can choose to “self-annuitize” their retirements if they are willing to deal with an indefinite period of time and the inherent investment risk of portfolio investments.
In this situation a retiree must spend more conservatively to account for the possibility of living beyond age ninety while also being affected by a poor sequence of market returns in early retirement.
At my firm, our answer to the sequence of returns risk is to maintain about a 5-year “war chest” of bonds and fixed income to take withdrawals from if the market goes down. This gives the equity portion of the portfolio time to recover.
An advisor can help you determine if an income annuity is right for your situation. I would recommend working with a CERTIFIED FINANCIAL PLANNER™ rather than an insurance agent, because a CFP® professional is a fiduciary and required to put your best interests ahead of their own personal gains.
A CERTIFIED financial planner™ professional can help you plan for your retirement. Schedule a call today so we can talk about your retirement situation.