Aug. 26, 2019
‘Whatever you do, don’t try to sell us an annuity.’
When 60-something couples visit a financial adviser’s office for help with retirement planning, these are often the first words they say after sitting down. Most of what they’ve read about annuities has been eye-glazing or frightening.
But don’t write off annuities yet. Owning annuities can pay off in the long run—especially if you’re married and in decent health, don’t have a gilt-edged pension, and aren’t sure that your savings will support you (and your surviving spouse) indefinitely after you stop earning a paycheck.
“Indefinitely” is the key word here. Nobody knows for sure how long retirement will last, how much they need to save, or how much they can afford to spend each year in retirement. Annuities help you deal with the financial implications of those uncertainties.
The word “annuity,” unfortunately, tends to get in its own way. People use it almost indiscriminately to describe five or six distinct financial contracts that serve different purposes for different people at different times.
Each type requires a separate explanation, and it’s hard to compare them. Annuities that are sold as investments-with-insurance-options or insurance-with-investment-options—and they often are—can be especially confusing.
The upside of annuities
We’ll unpack those complexities in future columns. Here we’ll focus on the benefits of annuities that offer guaranteed lifetime income streams, either as an option or as a hard-wired service. They can:
Give you the pension you never had. You’ve heard a lot about annuities in recent years because fewer and fewer retirees enjoy a pension (besides Social Security) that guarantees income for life. If you don’t have a pension but wish you did, certain kinds of annuities are designed to fill that gap. Most are purchased with a lump sum. Monthly checks can start tomorrow, or not for several years.
Let you spend more in retirement. The most common retirement income strategy is to own stocks and bonds and spend only 4% of your balance each year (adjusted for inflation). The point of an income annuity is to let you spend more than 4% without increasing your risk of running out of money.
Give you more flexibility with the rest of your investments. When you cover your essential monthly expenses with safe income from Social Security and an annuity (and perhaps a side fund for emergencies and splurges), you can afford to take more risk with the rest of your savings. Owning an annuity doesn’t necessarily reduce your upside potential.
Let you worry less in retirement. The Dow Jones Industrial Average recently fell 750 points in one day. If you’re retired and have most of your savings in stocks, that’s cause for alarm. But if you can cover your basic expenses without selling stocks at a loss, day-to-day market volatility won’t rattle you as much.
Take a load off your kids. Older people often run short of money just around the time they fall and fracture a pelvis or a femur and require full-time assistance. If they don’t have long-term care insurance, their adult children can suddenly face a four-figure monthly bill for assisted living services. Guaranteed income from an annuity can ease the strain.
What’s the catch?
If annuities are so cool, why are they so, well, reviled?
You pay with a lump sum. Group annuities, like company pensions or Social Security, are built with monthly contributions over a lifetime. But when you buy an annuity at retirement, you pay hundreds of thousands of dollars (perhaps by selling some of your mutual fund shares) all at once. Most people resist that. Some life insurers now let you buy individual annuities over several decades with monthly deposits, but the idea hasn’t caught on yet.
Illiquidity. When you buy no-load mutual fund shares, you can, if you need to, change your mind and sell them a day or two later. Exchange-traded funds can be sold intra-day. That’s liquidity. Annuities vary from zero to partial to conditional to full liquidity, sometimes with a penalty. Illiquidity has its benefits, but it’s a deal-breaker for many people.
Expense. Annuities are expensive. They cost more than investments because they involve guarantees, and guarantees are expensive (until something bad happens; then they save you money). Low interest rates, marketing costs, sales commissions, the requirement for life insurers to hold reserves, and the tendency of only healthier people to buy annuities are additional factors that can escalate an annuity’s cost.
Resistance to spending principal. Most retirees would prefer to live on interest, dividends, and capital gains and never reduce their net worth. That’s a worthy goal. But for people who can’t afford to do that—because their nest egg isn’t big enough or they’d have to take too much risk with what they have—annuities can be an efficient solution.
Annuities are not for everyone, to be sure. But no middle-class Boomer couple in good health can afford not to investigate their potential value. Annuities can provide a sense of security that most American retirees want but don’t have. So when a 60-something couple visits a financial adviser, one of their first questions should be, “Could an annuity help us?”