Annuities Basics: When to Use Them and When to Pass

Disclaimer: The article below discusses certain investment strategies, some of which I am currently using in my personal portfolio and some of which I am not.  Do your own due diligence before making an investment decision.  It’s your money; you’re the best person to judge what is best to do with it.

Annuities get a bad rap, and rightfully so.  They are often sold with aggressive sales tactics, lots of hidden and expensive fees, and contract language that even most lawyers would struggle to understand.  Annuities are not investments, which means they are not governed by the SEC and other regulatory bodies, nor do they have the same disclosure requirements that mutual funds or ETFs have.  Further, there are a gazillion different types of annuities with different options associated with each.

My goal here is not to try and explain the highly detailed ins and outs of annuities and their different flavors.  There is plenty of literature out there on that.  Instead, my goal is to discuss when it may be worth it to buy one for your portfolio.  Regardless of what others will tell you, there is only ever one reasonable choice in the annuity world, and that’s only when you’re at or near retirement.  It’s a Single Premium Immediate Annuity (SPIA) with payments adjusted for inflation.  Ignore all the rest.  And even then, your personal situation will dictate whether or not you want to entertain looking at annuities.

Annuity Basics

Even though I won’t get into the fine details of what an annuity is and is not, it’s important to have at least some background before going forward.  Annuities are products that are most often offered by insurance companies to the general public.  However, there are plenty of other annuities out there; we just often call them something else.  A defined benefit pension fund is simply an annuity, as are a lot of high level, senior executive retirement plans.  For the purposes of this article, we’re going to take a look at those products offered to the general public, almost always by insurance companies.

An annuity is not an investment, but rather a contract between you and the insurance company.  You have no legal claim to the principal once it’s paid beyond what’s in your contract.  Some annuities have an expectation of a return of principal, while others don’t.  For an SPIA, you have no claim to the principal once it’s paid.  Instead, you have a legal interest in the stream of payments themselves.

Which brings about a crucial point: the counterparty (the insurance company) that you select impacts your annuity.  Insurance companies, just like banks and other financial institutions, can and do go bankrupt.  However, insurance companies, unlike banks, are often much safer and more conservative institutions.  There is no ability to start a “run” on the insurance company, and they use far less leverage.  While a bank may only have 7-10 percent of assets per dollar of liabilities (e.g. the bank is leveraged 10-15 times), an insurance company is typically in the 70-90 cent range (e.g. the insurance company is leveraged 1.1-1.5 times).  There have been fewer than 80 insurance company failures from 1987 to today, while there were 157 bank failures in 2010 alone!  Insurance companies do not have an FDIC like banks do to protect deposits, but insurance companies must pay into each state’s Guaranty Association, which steps in and helps make consumers whole in the event of a failure.  In order to protect yourself, focus on buying from only high quality insurance companies.  If you plan on buying a substantial amount of income from an SPIA, diversify among several companies.

Finally, there are many, many different types of annuities out there.  There are many flavors of variable and deferred annuities, where you put money away each month and invest it in your choice of mutual funds.  Stay away from these, as the fees are egregious.  The most common SPIA is simple: pay the premium once, and receive a fixed stream of income for life.  Unfortunately, the common SPIA does not include an inflation adjustment, so the income stays fixed for however long you choose.  Even though you would receive a higher payment up front, the lack of inflation adjustment makes it too dangerous in the long term.

As mentioned in the intro, the only annuity even worth considering is the Single Premium Immediate Annuity with inflation adjusted payments (italicized and underlined for a reason!).  You pay a lump sum up front in exchange for monthly payments for the rest of your life, adjusted each year based on the measured rate of inflation in the economy.  For a 67 year old couple, the initial payout currently is between 4-4.3% (a single person will get a higher payout).  Not great by any stretch, especially considering your life expectancy is probably 20-25 more years.  But it’s also not terrible, and it removes all investment and inflation risk.  These contracts are actually fairly straightforward (at least as far as annuity contracts go), and it’s easy to compare across firms.  Unlike variable or deferred annuities, all fees and expenses are typically embedded in the payout amount.  A higher cost firm will have a lower payout amount, so you can choose an annuity based on two major inputs: the strength of the insurance company and the payout they offer.  Typically, commissions paid up front to the insurance agent or broker are in the 1-5% range, but these are hidden from you as the insurance company pays the agent or broker directly.  It’s incredibly frustrating that you cannot buy annuities direct from insurance companies, as this would reduce the cost substantially.

When to Use Them

SPIAs with an inflation adjustment do have their place.  In fact, there are a few specific instances when it makes a lot of sense.  The first is highly personal: when you are very risk adverse and have an innate fear of running out of money.  Let’s assume that a 65 year old couple has basic household expenses of $5,000 per month, and receives a total of $3,500 per month from Social Security.  They have a retirement portfolio of over $1 million.  In order to fully cover their basics for the rest of their life, they would need to spend between $400,000 and $450,000 to purchase a joint survivor, inflation adjusted annuity that provides the additional $1,500 per month in income needed.  This is not a cheap option, but assuming this couple has a conservative risk profile, they would be able to cover their basic expenses for life, and still have over $500,000 left in their investment portfolio.

Secondly, life expectancy matters with annuities – a lot.  Insurance companies pool together the average life expectancy of all of their annuitants.  Some die before the average age, and some die later.  For the insurance company, so long as the average life of the entire group is close to their expectations, they’ll be fine.  For you, however, passing away early would be a huge financial negative if you had bought an annuity (it would be a huge negative overall, for other obvious reasons!).  If your family has a history of living well into their 90s and you are in good health, then an annuity could be a net winner.

Finally, and probably most importantly, market environments matter.  If you were just starting out retirement when markets are cheap (e.g. early 90s, 2009, etc.), then buying an annuity makes no sense.  Odds are stacked in your favor that you would do much better investing yourself.  On the other hand, when markets are expensive and future expected returns are low, passing that risk to an insurance company can be beneficial.  As discussed in my post about Never Touching the Principal, withdrawing money from a portfolio comes from two sources: income and principal.  When income generation is low, you’ll need to pull more from the principal.  This is when market dynamics become much more important.  A 60% stock/40% bond portfolio only generates between 2-2.5% per year in income.  In the 90s, that number was over 3%, and in the 70s and 80s, it was well over 4%.  Goldman Sachs recently released a study that said a 60/40 portfolio is the most expensive today since at least the year 1900.  At least the year 1900!  Find me a safe withdrawal rate study that incorporates that.  Expensive markets make SPIAs more attractive, even with their correspondingly low initial withdrawal rates.

When to Pass

One of the biggest determinants of using or not using an annuity is your Social Security check.  Remember that Social Security is just a government sponsored inflation-adjusted annuity.  For example, a high earning single male can take Social Security at age 62 and receive around $2,000 a month, take it at age 67 and receive around $2,900 a month, or at age 70 and receive around $3,600 per month.  A 62 year old male can also receive $350 per month for $100,000 from an inflation adjusted SPIA (4.2% per year).  Being able to wait eight years and take Social Security at age 70 instead would be equivalent to buying $450,000 worth of inflation adjusted SPIA.  Using that $450,000 for living expenses for eight years, assuming no return at all, would allow you to withdraw $4,650 per month during that time.  The difference between taking Social Security at age 67 and taking it at age 70 is $200,000 to purchase an equivalent annuity payout.  In other words, Social Security is the cheapest and best inflation adjusted annuity around!  If the alternative in early retirement is between an annuity, or spending your principal while waiting for full Social Security benefits, then you should absolutely spend your principal and wait to take Social Security before buying an annuity.  Of course, all this assumes that you’ve got a big enough portfolio, as spending down your entire portfolio by age 70 would be a bad strategy.

One of the biggest drawbacks of an SPIA is that once you pay the premium, it’s gone forever.  If you want to leave something to your heirs, and feel comfortable taking the investment risk, then buying an annuity is the wrong course of action.  Also, you’re playing the numbers game with life expectancy.  Remember that an insurance company pools all of the annuitants, so they are able to pool the risk of you outliving the overall population against other people dying early.  This is the inverse of above – if you have a family history of early heart attacks, then an annuity may not be for you.

Finally, if you feel comfortable taking the investment risk, are really uncomfortable giving up a lump sum to the insurance companies, and have more than enough in your investment accounts, then feel free to skip the annuity.  Even in situations like these, if the market is expensive, I think it’s worth it to annuitize your basic expenses.  But if you only need $50,000 per year on top of Social Security, and have $5 million in the bank, go ahead and leave the annuity alone.  You won’t need to worry.

Don’t Automatically Dismiss Annuities

Because of the bad press, much of it earned, many people automatically dismiss annuities.  Most annuities are bad products, but a Single Premium Immediate Annuity that is adjusted annually for inflation can and does have its place.  On the personal front, risk aversion verses life expectancy will help guide this decision.  From an objective standpoint, market dynamics versus the ability to delay Social Security will push one way or another as well.  My advice is to delay Social Security if you can, as this is the cheapest annuity you can buy.  However, given current market dynamics, if you are terrified of running out of money, do your homework, shop around, then feel free to buy that annuity.

Keep building my friends.

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