Using Annuities as Part of a Retirement Plan

Annuities have a bad reputation, with a history that makes that bad reputation sensible. The main problem is the high costs (and often hidden costs) of many annuity products. Combine with large sales incentives this has led to annuities being abused by sales people and financial companies while providing poor returns to investors.

However the attributes of annuities fit a specific part of a retirement plan very well. Overall I am a big fan of IRA, 401(k), HSA – all of which provide the investor with control over their own financial assets. And I still believe they should be a large part of a financial plan.

In order to save for retirement, we need to start young and save substantial amounts of money to live off of in retirement. Retiring early requires that investments provide income to live off of for an even longer time.

Pensions provided an annuity (a regular payment over time). Social security (in the USA, and other government retirement payments internationally) provide an annuity payment.

A rough rule of thumb of being able to spend approximately 4% of the initial retirement investment assets (given a portfolio invested in USA stocks and bonds) gives a starting point to plan for retirement. That 4% rule however is not guaranteed to work (especially if you live outside the USA or retire early). In fact relying on it today seems questionable in my opinion (not only even if you retire at 67 in the USA (given the current seemingly high values in the stock market).

The best roll for an annuity in retirement planning in my opinion is to serve as a protection against longevity. The longer you live the more risk you have of outliving your investment savings. Life annuities have the benefit of continuing for as long as you live.

One of the disadvantages of a life annuity is that the principle is not yours to leave to heirs. That is a fine trade-off for protection that you have enough to live off of in most cases. And I wouldn’t suggest having all of your money put into an annuity so if leaving assets to heirs is important you can just factor that into the balance of how much you put into the annuity down payment.

John Hunter with lake and mountains in the background

John Hunter, Bear Hump trail, Glacier-Waterton International Peace Park

It is possible to have the annuity pay for as long as either spouse lives (so if that is a concern, as it would likely be for most married couples, that is a good option to use). The payment will obviously be less but not by a huge amount (though if one spouse is many decades younger, then the amount can be substantial).

An annuity payment is calculated based on projected investment returns and your life expectancy. The older you are the larger a percentage of the initial deposit you can expect as an annuity payment. Something like 5.5% if you are 65 today may be reasonable (this will change as investment projections, especially interest rates, change). So one thing you will notice right away is that is much greater than 4%. And that shows one advantage of using annuities.

Why is the annuity able to provide payments greater than 4%? A big reason is that the insurance company can balance the payment based on a large number of people. And many of those people will die in 10 or 15 years. That allows them to retain the assets they were investing for those individuals and still continue payments for those people that live for 25, 30+ years.

This basic tradeoff is what makes annuities so appealing. As an individual you need to protect yourself from the risk of outliving your assets. An annuity does this. And if you die early you lose money that you can’t use anyway. Essentially you tradeoff the benefit to those you would leave money to (charities, your heirs, etc.) in order to gain protection for yourself.

You can even increase your longevity protection by buying deferred annuities. You make a deposit today but instead of receiving annuity payments immediately they can start in many years. So for example, you could buy an annuity to start payments when you reached 80 years old. To receive $1,000 a month at age 80 (15 years in the future) you would need to make a deposit of just $47,976 (figures as of today on Vanguard’s site). Obviously the insurance company is counting on many people never getting a payment and few people from getting payments for decades. But again, this is a sensible way for an individual to buy insurance that protects them from outliving their savings.

So one strategy you could use is to buy such a delayed annuity to provide some additional income in case you outlived your projected life span. And doing so would reduce the risk that you run out of money if you live for a long time, since later in life you would require less from your investment portfolio (that is you could reduce below 4% [or whatever you were using as a guide] and maintain your income). The delayed annuity could also provide a protection against inflation (either general inflation or perhaps those relating to old age – long term care etc.) buy giving your income a boost if you manage to live past the age at which the new payment would start.

Especially in the current low interest rate environment I think putting a portion of retirement savings into an annuity makes a great deal of sense. As always you have to be very careful with investing in annuities to avoid being taken advantage of. This risk of being taken advantage of is definitely a drawback of investing in annuities.

The insurance companies are regulated to provide greater protection against investors losing out when an insurer goes bankrupt. This risk is another complexity of investing in annuities. Taking care and investing from a state (in the USA) that hasn’t gone crazy with getting rid of consumer protections has historically been safe. However the recent extremist measure by some states (only states controlled by the most extreme Republicans as far as I know) recently make relying on effective consumer protections a risky affair. I would greatly reduce my investing in annuities from states that have shown such extremism in anti-consumer regulation.

It is possible to get annuities with inflation escalators (so payments increase over time to factor in inflation) but these will reduce the amount of initial payment (or greatly increase the amount of deposit needed).

Annuity payment rates are very much influenced by long term interest rates. So the payment rates are depressed today (given are long term low interest rate environment) – though as we noted above, they are still greater than the “4% rule of thumb.” Still it does lock you into that low rate.

For someone with no pension and limited social security coverage there are very good arguments for using an annuity or a deferred annuity or both. You must spend much more time to carefully pick the right options for you (given the risks) but it can be a very good fit to reduce a real risk of outliving your savings. And it is possible to do so without reducing your current available income (it even increases it from the 4% rule of thumb). However the value of the flexibility of an investment portfolio (as well as the benefits of stock ownership over the long term) mean that I think it is wise to make annuities only a portion of a retirement plan. If I bought both and immediate and deferred annuity I would almost certainly use different insurance companies (again just to reduce risk).

Many (all?) states do provide insurance to cover you in case your insurance company goes bankrupt but those limits can be as low as $100,000 net present value (some states it goes to $500,000 – so again the consumer protections your state has need to be understood and your decisions adjusted based on those facts).

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