Annuities, what are they and should I get one?

When I talk to people or give presentations I always talk about how easy it is to become a millionaire and how important it is you strive for that. I use that number because it is a nice big round catchy number. Last week I talked a little about what it means to have a million dollars and what you can and should you do with it once you have it? I am going to use that same nice round number in doing some comparisons on annuities.

Let me start out with a full disclosure. I do not hold any annuities myself, (I will have a traditional pension at 65) and I think they are a poor investment option for most people and in most circumstances. This belief is partly because I am an aggressive investor and partly because they are part investment product and part life insurance product. I work in the insurance industry in my day job, and know the importance of insurance.  I just don’t think people should buy anymore insurance than then need and they should not mix insurance and investment products together, with the exception of using them for certain tax strategies.

My prejudices aside, I think anyone investing for retirement should at least understand annuities and based on their risk tolerance and personal situations consider them as an option for part of their portfolio. This is even more important for people that do not have a traditional pension (a pension is essentially an annuity).

The definition of annuity is “a fixed sum of money paid to someone each month or year, typically for the rest of their life. A form of insurance or investment entitling the investor to a series of annual sums.”

Sounds simple enough, and the allure for many people is the “fixed sum of money”. The problem is what it cost you to get that “fixed sum of money” is quite complicated and often much more expensive than purchasing a mutual fund. On top of that they have lower rates of return than you would get by investing the money yourself in the stock market through mutual funds and ETFs. Annuities tend to have high commissions and/or management expenses, considerably higher than some of the best mutual funds and ETFs. Because annuities are giving you a “guarantee” there is the insurance component you are also paying for.

Now days there are all types of annuities, some that guarantee you minimum return rates others guarantee you a fixed set of payments whether for life or a set term. They all have very complex rules some of which allow the insurance company to change the rules during the term of the contract. They often have horrendous surrender fees if you latter change your mind and want to go in a different direction. Therefore; it is critical, if you are going to consider an annuity, that you read the paperwork carefully and understand it. I would also recommend you ask someone knowledgeable about investments, that you trust, (other than the sales person) to review the contract before you sign it and ask them to plays devil’s advocate and point out potential concerns.

Things to look for are the surrender fees should you change your mind or need the money. Minimum length of time you have to stay in the contact, and guarantees they are giving and the ability of the company to change the terms. You also want to know the financial ratting of the insurance company that issues them because if they go under the guarantees are meaningless.

Finally consider what you are giving up once you sign the contract. The traditional annuity is an all or nothing product, you give them your money for guaranteed payments for the rest of your life. If you die tomorrow your heirs get nothing. On the other hand if you were investing your money your heirs get whatever is left of your principal. While you can add survivor benefits or payments for a guaranteed amount of time to the contract of annuity, any such changes generally lowers you monthly payment for life. The more options you add the more complicated it gets. Not so simple anymore!

While the sales people and marketers will tout the “guaranteed income” for life they usually fail to mention that it is a fixed income. They certainly don’t emphasize how inflation can erode that. If you ask about inflation they may offer and addition to the contract that gives you a 2% increase every year, but this of course lowers your initial payments and does not help you in years of higher than usual inflation.

I always think it best to give you some real numbers. Last week we used a million dollars as an example and taking out 4% in the first year and then adding the rate of inflation each year thereafter. That should last most people’s life times with money left over for heirs. If you took the same million dollars at age 60 and bought a joint life annuity for you and your spouse you would get a guaranteed payment of about $51,000 a year. If you’re not married, an annuity for a single male would get you about $58,000 a year. If the single male wanted to add the 2% increase rider they would get about $46,000 in the first year with a 2% increase each subsequent year.

Again it looks simple as all those number beat the $40,000 you start with by investing yourself. But retirement planning is complicated, don’t always accept the simple answer without challenging it. Besides the fact that you lose all your money with nothing for your heirs under the annuities described above, what happens if you live a long life? How long does it take for your inflation adjusted self -investment to outpace your annuity? Assuming you increase your self-invested withdrawals the average rate of inflation (3.15%) in just nine years you outpace the joint life as you will be taking out $52,879 a year and growing for the rest of your life as opposed to the fixed amount of $51,000. Most healthy people will live will beyond 69 years old.

What about the single life? Whether you chose the fixed or 2% annual increase it takes about the same amount of time to catch up to the payouts, 12 years or age seventy two. After age 72 the gap grows every year. Just like when you were saving for retirement you have to consider your future needs, when you are looking at spending your retirement savings. People are living longer and you don’t want to be on a fixed income for thirty or more years. 

So you while you might want some guaranteed income besides social security in your portfolio for retirement, it is also important that you have a hedge against inflation which is hard to get with any fixed income scenario.

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