In my last article on annuities, I discussed the different types of annuities and their use inside retirement accounts. As you could probably tell, I'm not a huge fan of variable or indexed annuities, especially when used for retirement saving and investing inside an IRA.
My biggest concerns have to do with their complexity and high costs relative to other investments. But to be fair, some are better than others and these products are evolving and even better ones are starting to come on the scene that may warrant a closer look in the future.
I do however have some interest in fixed annuities because of their potential for providing "pension-like" retirement income for life. Therefore, I have been reading a lot about both immediate and deferred fixed annuities, including newer products intended to address some of the cost and liquidity concerns.
I used to look askance at all annuities. Based on the overall performance of the stock and bond markets for the last 20 years, who needs them, right? Balanced stock/bond portfolios have been averaging 4% to 6% per year with moderate risk. Plus, a lot of independent financial experts question the more complex and high-cost variable and equity-indexed annuities. And even if you really wanted to purchase one of these products, making objective comparisons was very difficult.
I have generally held to Dave Ramsey's advice to keep your insurance and your investments separate. Variable and Indexed Annuities are really combinations of both. Dave is not a big fan of annuities and says,
The bottom line here is that while a guaranteed income is great, your earnings potential is much greater with mutual funds. Stick to a simple plan: Invest 15% of your income in mutual funds through tax-advantaged accounts such as your 401(k) or a Roth IRA.
I understand his advice and I don't disagree in principle. I am just beginning to think that adding a guaranteed income component beyond what you get from Social Security to your retirement plan may be a wise decision for many people. And what I am mainly talking about are immediate fixed annuities, commonly called single premium immediate annuities (SPIA's), not necessarily their more complex and expensive cousins that mix investing with insurance.
With an SPIA you pay an insurance company a lump sum and they immediately begin paying you a monthly amount. How much and for how long depends on the size of the lump sum, your age, and your chosen payment options – no stock market variability, no indexing, no extra fees – just simple, low cost, reliable retirement income.
And how much you receive from an SPIA over your lifetime depends on how long you live. Die early – you lose; but if you live long, you may get back much more than you put in.
Now you could buy a deferred fixed annuity inside an IRA that would payout sometime in the future, but as I discussed in the last article, there really isn't a compelling reason to do that during the accumulation/growth phase. Instead, you could fund an SPIA with some of your IRA assets when you retire, or later on when you want to start receiving income. Your money would remain directly invested in low-cost mutual funds during the accumulation/growth phase.
You could also consider a variable or indexed annuity at that time, especially as those products continue to improve. But I tend to view SPIAs more favorably and as basically functioning like another asset class in diversifying a post-retirement income portfolio. Plus, unlike other assets, they offer the added bonus of mitigating longevity risk, which is the chance you'll outlive your retirement savings.
Are annuities biblical?
Like so many contemporary topics, the Bible doesn't talk about annuities specifically. So, we have to look at biblical principles for guidance. The use of annuities as part of a retirement strategy could be viewed as wise stewardship of the resources God has given you and a good way to provide for your family in retirement as commanded in 1 Timothy 5:8.
Also, pensions and annuities aren't new – they were provided as far back as ancient Rome and Greece for service in the Army. More recently, gift annuities have been offered by many Christian non-profit organizations as a way of raising money.
Why consider annuities?
Why my growing interest in immediate annuities? Well, first of all, we experienced a historic market crash in 2008-2009. Because I had a fairly balanced portfolio at that time I weathered it fairly well, but I still took a big hit. You probably did too – most people did. It occurs to me that if I had been retired at that time I would probably have felt much better about receiving a guaranteed annuity payment instead of having my future income dependent on the stock market.
The next thing that has caused me to reconsider annuities is the simple fact that there is a 50% chance that my wife or I will live well into our 80s, or perhaps longer. If I retire at 65 or 70, that would mean a LOT of years in retirement, which means the need for a LOT of years with reliable retirement income.
Since none of us actually know how long we will live, perhaps it would be wise to let the insurance companies assume some of that risk by pooling our money (and lifetimes) with thousands of others in an annuity pool to ensure that none of us run out of money. Not to be morbid about it, but that works simply because some will die younger than others, and those that do will help support those who don't. That's the basic operating principle behind annuities.
One other thing that made me take another look was the fact that, at some point in life, I may want to put our finances on auto-pilot. Because the day may come when I am no longer able to manage things, or not in the picture at all, I want my wife to be assured of an ongoing income without worrying about managing some investments.
Because of this, I am giving some serious thought to adding an annuity with some of my assets. I probably won't do that right away, but as we grow older it may make sense to create a reliable "income floor" for the remainder of our retirement years.
Create an "income floor"
I took this idea of creating an "income floor with an upside" from Steve Vernon's excellent book, Money for Life. Steve is a retired insurance actuary who has an excellent grasp of retirement income planning and longevity. It has also been espoused by several economists.
An income floor is simply an income stream that meets your basic, essential living expenses (what Dave Ramsey would call the "four walls": food, clothing, shelter, and transportation; plus, for retirees, I would add health care expenses, taxes, and giving).
You start by identifying your essential living expenses – the things you can't live without. The rest is considered discretionary spending that could be suspended or eliminated altogether if absolutely necessary – things like travel, entertainment, recreation, etc.
Then you need to identify all guaranteed, inflation-adjusted sources of income you can rely on in retirement. For most, that will be Social Security and perhaps a pension. Some may also have real estate income or income from government treasury inflation-adjusted securities (known as "TIPS"), or I Savings Bonds, which are also in this category.
If your essential expenses exceed your guaranteed income, as they will for many, you may want to fill the gap with additional guaranteed income sources. One way to do that is to annuitize or purchase a guaranteed lifetime withdrawal benefit with whatever percentage of your savings is required to make up the difference. Basically, you would hand over a portion of your nest egg to an insurance company (or companies, for diversification purposes) and in return get a lifetime income stream.
For example, let's say you estimate that your essential living expenses in retirement will be $40,000. If you receive Social Security benefits of $25,000, you will have a guaranteed income gap of $15,000. Based on a quote from immediateannuities.com, a purchase amount of $250,000 would be needed for a 70-year-old couple to receive a lifetime income of $1,200 per month. If you get an inflation adjustment option, the amount will be less.
Of course, whether you would want to part with $250,000 in savings to receive that income is another matter. $250,000 earning 4% per year in mutual funds would generate $833 in monthly income, but it would NOT be guaranteed. So for some, annuitizing a portion of their retirement will be essential to generate the income they need.
This may not be a big concern for you IF you have enough savings and a low enough withdrawal rate such that can weather most conceivable economic conditions over most conceivable life spans. But the reality is that very, very few of us will be in that category. And even if you are, you may experience greater financial peace by purchasing a small annuity.
Invest for an "upside"
One of the best things about this approach is that once you build your income "floor" to cover your essential retirement expenses, you then have some flexibility in terms of how you invest your remaining assets. You can position them for a possible "upside".
You might do that by investing the bulk of those assets in the stock market and taking some moderate risk, or not, depending on your risk tolerance. (If I was to pursue this strategy, I would probably just continue to maintain a low cost, diversified, balanced portfolio for the remainder of my assets.)
For simplification purposes, I may even put them into a single "all-in-one" balanced fund like one of the LifeStrategy or Target Date Retirement Funds from Vanguard. You could then just consume the income from that portfolio, or you could choose to gradually sell assets (principal) for discretionary things or activities, or for giving.
Looking back at our example, if, after purchasing a $250,000 annuity you have $250,000 remaining that can generate income of 3%, you will have an additional $7,500 per year in income without having to liquidate any assets. That means you would have a total income of $47,500 per year, with $40,000 to cover your essential expenses. If the financial markets do well, the remaining $250,000 could grow substantially over the remainder of your lifetime. If not, you would still be able to cover your essential living expenses.
In most cases, if you only withdraw the income from your investments, they should grow enough to compensate. But there's no guarantee – in some cases they won't. But no matter what, you can be fairly sure that you can continue to pay your bills even if your investments take a big hit or even go to zero in your later years. That's because years before you will have established a baseline of guaranteed income for life using Social Security and annuities.
So what about Variable Annuities?
Variable Annuity products are getting better. For example, Vanguard's variable annuity product with the "Secure Income" benefit (Vanguard's term for a guaranteed lifetime withdrawal option) appears to offer the transparency, simplicity, and low expenses that you would expect from them. A 65-year-old couple would pay 1.2% annually in fees to guarantee a 4.5% withdrawal (joint life rider) against the Total Withdrawal Base (TWB), which can fluctuate from year to year based on the performance of the underlying investments. Not a bad deal, but it depends on what you think about the future of the financial markets and a 1.2% annual fee.
I may consider purchasing an annuity before my wife and I turn 70. I lean toward the more straightforward SPIA coupled with a standalone balanced investment portfolio to create an "income floor with an upside" rather than an all-in-one variable annuity product. However, with improved products coming on the scene, more study and analysis will definitely be needed before I make a final decision.
What's the risk?
You need to keep in mind that annuities are not risk-free. Variable and Indexed Annuities carry market risk. Even SPIAs, in a worst case scenario, carry solvency risk. Although annuities are sometimes sold as a "sure thing", they are actually insurance contracts that are only as good as the insurance company itself. The bet you are making is that the company will stay in business and able to make payments to you and all other annuitants for their lifetimes.
Normally, that would be a pretty good bet. Insurance companies are heavily regulated and insured, and most are very profitable. But, as we all know, there can be abnormal circumstances that need to be considered. If economic conditions become extremely bad, there could be some concerns about insurance company solvency. It's possible that insurance companies could be negatively impacted just like all other financial companies.
Increasing lifespan is also a potential risk for insurance companies unless they account for that in their actuarial analysis and cost structures.
Also, a risk to you is that you will die young and not receive a lot of benefit from the annuity or have that money left for your heirs.
The bottom line is that any part of your retirement income that depends on private or public pensions is only as good as the companies and/or institutions standing behind them. Given an extreme scenario, no retirement income source is free from solvency risk.
Here are some key takeaways from this article and the one before it (Annuities – Part 1):
- Adding an annuity to your retirement income plan may be a good way to mitigate longevity risk. The "floor with an upside" strategy is one way to do that.
- An annuity – fixed, indexed, or variable – isn't actually an investment in the typical sense. Rather, it is a contract between you and the insurance company that issues the annuity.
- People with very low savings should probably not buy an annuity if they will be left with little for no cash for emergencies or unplanned expenses. Those with much higher savings may not need one at all if they can generate enough income for essential expenses with some upside for growth to help with inflation. It's the folks in the middle who may be concerned about their savings lasting a lifetime who should consider them.
- Fixed annuities protect against market declines whereas most indexed and variable annuities do not. You may do better during recessionary times with fixed annuities than indexed or variable ones.
- A fixed annuity will provide a guaranteed payout for life. A guaranteed payout option may also be available with indexed and variable annuities, but typically at additional cost.
- The main risk of principal loss with fixed annuities is early death, but optional policy terms can reduce this risk (such as payments to a surviving spouse), but with an added cost.
- The main risk of principal loss with indexed and variable annuities is market risk, but there are optional policy terms that can reduce this risk, also with an added cost.
- If you decide to purchase an annuity, do your homework. Look at several different companies and compare prices, and consider purchasing from more than one company for diversification. Make sure you completely understand any product you decide to buy.