Annuities are a polarizing topic. The FIRE community generally has zero use for them. But financial advisors, even fee based fiduciary financial advisors, quite often recommend them. In fact, a retirement planning expert I highly admire and respect even included one in the detailed financial plan he did for me and my wife years ago. He doesn’t sell them or get any kind of commission, he just honestly thinks they make since for someone like me, maybe for most people planning retirement.
So what is the truth regarding annuities? I will lay out the common arguments I am familiar with, pro and con, and let you decide. First, the case for annuities. One of the biggest problems with determining if you are truly financially able to stop working is the fact that none of us know how long we will live. If we knew that it would be fairly straight forward to come up with the amount of investments, savings and/or passive income we would need to quit work and retire. The standard consensus figure that is most commonly thrown around is you need twenty-five times your annual expenses invested to have enough money. There are a lot of assumptions built into coming up with that. Its also known as the four percent rule, because if the assumptions hold true in the future, you can safely draw four percent of your investment portfolio out the first year of retirement and then draw that same amount of money, adjusted for inflation, every year after that. But what about those assumptions?
And there is the rub. Those assumptions include that you have a significant exposure to stocks (50% or higher), that’s simple enough. They also include assuming that all future stock and bond performance will be the same as it was in at least one of the past thirty year historic sequences. In other words the future will not be different from the past. Now that is quite an assumption when we have record national debt, new things like crypto currencies and a stock market that is setting records for price to earnings. It also assumes you are invested in low fee index funds and never panic sell and always faithfully rebalance your allocations. But the biggest assumption of all is that you only need to fund thirty years of retirement. Now for a guy like me who retired, mostly, at sixty that’s probably about right. But for many of you, planning to retire well before that age, you will still be pretty young after thirty years has transpired. What financial planners call that risk, that you’ll outlive your money, is longevity risk. And it is a real thing.
And what do we do to control risk? We buy insurance. We insure our car because we might hit someone and hurt them and get sued. We insure our house because the Fed Ex woman might trip on our front step and, yeah, sue us. Or it might catch fire and burn up along with all our stuff. We even insure our death with a product nonsensically called life insurance, because when we die our income dies with us and we may have people who were depending on us. So how can you insure against living too long? That is what an annuity is, it is insurance against out living your money. The concept makes sense for the same reason those other insurance policies do. Car insurance is cheap compared to the cost of getting sued for crashing into another car. Home insurance is pretty cheap compared to rebuilding your house if it burns down. The reason insurance isn’t super expensive is because most of those bad things you insure against do not happen very often. So if one person in a thousand has their house burn down the other nine hundred ninety-nine people who never have a claim help pay for rebuilding the house through their insurance premiums.
An annuity is much the same. First let me clarify I’m only talking about the type of annuity that pays you a fixed amount of money each month after it starts, and it never stops paying that fixed amount until you die. If a vampire bites you and you live to be five hundred years old the insurance company will still be paying you that same monthly check. And that is how it insures against living too long. As long as you are still ticking the checks will keep coming, it is the ultimate mailbox money. Financial planners that favor annuities usually do not try to provide for your entire retirement expenses with an annuity but generally separate out what you need to live a “no frills” dignified life and buy a big enough annuity to cover those costs. They will usually recommend putting the rest of your investments in conventional things like index funds and bonds and cash and to use that money for emergencies and “frills”.
It makes sense and should take less money to fund than it would to invest enough of your money in stocks and bonds to provide the same income. Let’s do the one thousand people thing again. Say one thousand people buy annuities that start paying at the age of 60. The average life expectancy of those thousand is, let’s say, eighty-eight years. The fact is some of them will die in their sixties and seventies. And when they die the insurance company stops writing them checks. So maybe they paid $500,000 to get an annuity that would pay them $2,125 per month( real numbers from TIAA’s annuity calculator). Well if someone dies at age 61 the insurance company just made a $474,500 profit off that person because they only got back twelve months worth of checks for the half million they spent. And that money is available to write checks to all the geezers (being a geezer, I’m allowed to say that) that live past their life expectancy. So the geezers get a wealth transfer from those that die too soon to get their money back. And that is why a lot of financial advisors like annuities. They also make a big deal about the fact that annuities are a guaranteed contract, no matter what the stock market does the insurance company has to make those payments to you as long as you live. That is versus a four percent withdrawal rate that might stop working if the US some day becomes the next Japan with a market going down or sideways for decades.
What about those who hate annuities, why do they hate them? Lots of reasons. First you can usually earn a lot more by investing the money yourself than the insurance company will pay you. I mean, they have to make a profit and that profit is coming out of the monthly checks they write to you. And in many cases the fees charged by insurance companies for annuities in the past have been egregious. I think that competition has greatly improved that but it happened enough that many people permanently wrote all annuities off as over priced. Next, there is the risk you might die too soon to get your money back. And even if you don’t you still have nothing to hand down to kids or charity because that half a million you spent is gone, its being paid to the old timers who outlived you.
And that’s generally where the debate ends. Annuities are a good deal if you outlive all expectations and are pretty terrible if you die too early. But I think there are a couple more arguments against them that are not made very often, and they are why I have no plans to purchase one.
First, how good is that guarantee, really? When you buy index funds you are buying into hundreds, maybe thousands of companies. As long as they keep making a profit their stock will have some value. You are diversified, and there is safety in that. When you buy an annuity you are buying into exactly one company, just one, the insurance company you bought the annuity from. If they go under, like AIG almost did in September of 2008, they do not have to honor that contract. And the half a million you gave them, it might have vaporized. Annuity proponents will say, that can’t happen. That has never happened. But that does not reassure me much. Annuities are supposed to be the cure for the fact that the assumptions behind the four percent rule might be flawed. It is supposed to take care of the risk that past performance may not predict what will happen in the future. Well you can’t have it both ways. You cannot say the past is not reliable when it comes to estimating a safe withdrawal rate and also say the past is completely reliable when it comes to proving annuities are safe. As for me I’ll trust a huge index of domestic and global companies rather than one insurance company.
The second risk is inflation. Its an much bigger risk in my opinion. Annuity companies do not sell inflation protected annuities because inflation terrifies them. That first check they write, in my example at age sixty, stays the same amount even when you are hundred years old. Again, in my example the insurance company pays you $2,125 each month and you bought that annuity because that was what your minimum expenses were at age sixty. But using the inflation history I’ve lived through, across a forty year period, that $2,125 check is going to be nearly worthless. After forty years your expenses will have risen to $8,184 because that’s what inflation does. So how is that good longevity insurance? You will only have a fourth of what you need to live and you’ll be eating cat food, and not even premium cat food at that.
So for those reasons, and because my actual withdrawal rate is very low, far below 4%, I do not see annuities as being a fit for me. I am self insuring for longevity risk by having plenty of invested assets. I have a difficult time seeing them as a good fit for anyone but I’m no financial expert and they might be fine in some situations. And there are many other types of annuities. Some pay higher yields when the market goes up while protecting you from market crashes. Some have life insurance or long term care benefits mixed in. I’m not talking about those, though I am never buying them either.
So what say you? Do any of you have annuities or think you might consider one someday?
Do you think I’ve treated them fairly in this post or just did a hatchet job on an actually good product?
As always, should the comment box be hiding somewhere you can’t find it, just click on the title of the post.
Good overview and fair to both sides. I’m younger and don’t need an annuity yet but it seems like a generally losing proposition (which is why the insurers offer them in the first place). I have another pro and con for you:
Pro: Forced spending. I’ve seen annuities pitched as a way to make it easier to spend money in retirement by replicating a regular income. After a lifetime of saving, I could see myself struggling to sell assets and an annuity could be a good way to allow myself to spend.
Con: Estate planning. If you buy an annuity, the upside is guaranteed to go to the insurer. If you invest, the upside goes to your heirs.
Thanks Will, good points on the forced spending. That hasn’t been a problem for us but I think it’s common. And the lack of anything to hand down, that’s definitely a negative.
Great overview Steve. I honestly didn’t know much about annuities, so appreciate learning a bit and seeing some examples in your post.
I guess “peace of mind” could be a subjective pro for some people. Having “guaranteed income” could make people feel more secure and taken care of. I’m not sure I feel that way, but I’m also quite young and have a head start on savings.
I think that’s how they are sold but I don’t think people realize how fast inflation turns that fixed income stream into peanuts. Thanks, Joel.
Good Morning Steve,
Thanks for the write-up. The other 3 items I would like to add that would concern me about an annuity.
1. FX risk – you have currency diversification with global stocks.
2. Life Insurance vs. Run out of Money Insurance – Life insurance is great for sudden, rare, and catastrophic events. Running out of money should happen slowly if you manage your finances with some degree of diligence and adjustments will happen if necessary. It’s inevitable.
3. All insurance is still a losing bet – At the macro level, the insurance companies have to make money so the odds are against you. The history of the S&P500 is the opposite. Most of the time, over an extended period, you will make a winning bet.
Thanks for all your contributions in the space.
Excellent points, since I can afford to self insure against longevity risk then its a bad deal for me. I’m not sure if someone has barely enough or even less than enough if it might make more sense or not. Thanks, DAP.
well, the one reason i can think of why an annuity might be right for certain people for partial income replacement is fear. the person might fear they can’t handle otherwise withdrawing money to fund their life. we in the personal finance space are more or less DIY comfortable at least with the concepts even if we have someone else execute the paychecks. i can think of others who want nothing to do with even thinking about it because they think it’s too complex and “just send me a monthly check and i’ll accept likely substandard returns” seems like a good trade for them.
personally, i am putting our fixed income into preferred stock etf’s which carry quite a bit of price risk but generally don’t see much more than a 10% dividend cut in hard times on an already high yield. to each his own i guess.
That’s a good point Freddy, I do tend to make the mistake that everyone knows as much as the Smidlap, which admittedly is more than me. But in truth that’s a very small subset, and for younger readers they haven’t had the time yet to gain as much life experience either. It might be a safer trade off to get that reliable check than to be at the mercy of “advisors” who could churn your account and talk people into high fee investments that are not appropriate.
Well written and well argued Steve, great job!
Thanks, Dave. I tried to stick to basics. The annuity world is extremely complicated, just like the permanent life insurance world. In both cases I think it is that way on purpose to confuse the buyers. Its funny, my dad was an insurance agent, mostly selling business and car insurance but when he could sell whole life it was a big pay off for him. I was smart enough to never argue the point with him, he was a great dad who paid for a loan free education for me. But he was compromised on that issue. In fact I still have a $50K whole life policy he bought me which I keep for sentimental reasons.
Great post and great points. I just get a bad feeling about anything that feels like a sales pitch because someone is out to make money off of me. And like you pointed out, it’s one company rather than a cross section of the entire stock market. That just makes me really uncomfortable.
Your point about inflation is really good. Sounds like they’re counting on people to not understand that, and I bet most people don’t.
Never for me. Like you, I’d rather be my own insurance by setting aside more than I need and from several different sources.
I think smart people who understand personal finance aren’t targeted much by annuity marketers. I really think the inflation risk is the biggest flaw, and if it wasn’t they would still sell inflation adjusted annuities like they used to. They figured out that was too big a business risk the hard way and you can’t buy an annuity like that any more to my knowledge. Thanks, Mrs. FCB!
I’m really not a fan of annuities. That being said devils advocate, the one reason I can see to justify them is if your family has a history of mental decline at old age and no one else who can help you in those scenarios.
I’m still not purchasing any beyond my pension payout.
That’s a great point nobody else has made. It does have that kind of safety valve. Elderly people in control of their assets are frequently scammed. Money that is held in an annuity isn’t available for scammers to steal. Plus its the ultimate set it and forget it paycheck. So even if there are no unsavory people involved it saves an older and possibly confused person from mishandling money. Thanks Fulltime!
Here in Australia there’s a bit of a push now for superannuation funds to develop annuity-type products because the government is in a bit of a tizzy about the findings of the Retirement Income Review. They don’t like that there’s a (relatively) small contingent of superannuants who have massive savings in their super that they’re basically using to avoid tax and provide an inheritance for their kids. It’ll be interesting to see where it leads.
FireforOne, your system is very different as I understand it. Particularly when it comes to your version of what we call Social Security. In our case the more you were required to pay in, and I was required to pay the absolute max every single year of the 35 years they measure, the more you receive. It is slanted to poorer people, they get back much more than they pay in while guys like me get back much less than had we been allowed to put the same money in a brokerage account. But it has to sting for you folks to pay into the system your whole career and then be disqualified because you were successful in your career and made too much money and didn’t blow it all. But the part where people have millions tax sheltered away, that’s similar to the way some people have hundreds of millions or even a billion in their ROTH IRA because they paid tax on the money to buy stock or real estate that rose in value exponentially. Both our governments hate to see anyone get lucky like that! And both never saw a tax they didn’t like. Its kind of odd they create loopholes and then are “shocked” when people take advantage of the opportunities presented.
Ha ha, ain’t that the truth! I admit I find the US system a bit confusing. Here the pension is a given until you reach a certain level of income, whether that’s what you draw from super or from investments, and even then it’s scaled, so you could be earning a small amount and get a partial pension. I feel that our government is actually trying to shoot itself in the foot with this stuff because they do so much whingeing about having to provide pensions yet they’ve also been trying to block legislated rises to the minimum employer super contribution, which would mean more money for the individual in retirement so less reliance on the public purse. Funnily enough, they never seem to think the massive amounts of corporate welfare they provide are a waste of public money.
Well, I guess it is universal that wherever you live the government seems to be a little bit at odds with itself. As they say its always the worst form of government until you compare it to anything else. Thanks!
Annuities can make sense for those who are risk averse or that truly want to plan for everything. Personally, I am comfortable with variability of returns and modifying my spending habits accordingly; others may not be comfortable with this.
Annuities also get a bad rap due to them being oversold and complexities that can be involved. If you are going to get an annuity, it should likely be one that a layperson can understand. Additionally, it should make sense for your situation, not just because the salesperson needs to make a buck.
Excellent points Olaf, I do think they were oversold due to the hefty commissions. But having a steady “paycheck” coming in for the rest of your life would be a solid comfort. And added to an inflation adjusted Social Security check it could take a very long time before inflation ate away at the total. And maybe expenses would be naturally declining by then too.
There certainly is something to be said about a steady payment that comes in for the remainder of your lifetime. However, for me, the opportunity cost for me is too high. Nonetheless, as you said, they can make sense for people but they are a polarizing topic. I work in finance and using the word annuity can lead to an instant defensive posture by clients, which is unfortunate.
Another good post—particularly about an annuity being an act of faith in one insurance company. Just as aside, I have heard annuities marketed as a hedge against Social Security going broke… regardless of your beliefs in the future of SS it would be hard to argue that the risk of SS going broke is greater than the risk of any individual insurance company going belly up.. 😆😆😎😎
Jack, thanks, I think their track record is very reliable but so is the track record of the 4% rule. It seems disingenuous to sell them as protection against a future worse than anything that’s ever happened before and at the same time claim the past proves insurance companies’ can’t go broke. There is just something wrong about that logic.
“how good is that guarantee, really?” Exactly the question that I asked myself. If stock market returns are low enough that I need the insurance of an annuity then how will the annuity company be able to fulfill its obligations?
Where I might eventually consider it is around age 75 or 80 when the mortality credits really start to pay out and my mental faculties will be in serious decline. It might let me accelerate living gifts to my heirs who need it.
Caroline, you said it better than I did.
This is a very much needed post and I’m glad you’ve taken the initiative to write about this!
https://www.kitchenmitts.com
Thanks Mitts, I appreciate the kind words.
As they say, ‘the cheapest insurance is self-insurance.’
I thought this was a good overview, and a balanced one! The fact is that an annuity makes sense for some folks, based on one’s personality and one’s situation–but it therefore doesn’t make sense for others.
My perspective is currently the same as yours; I think I’m better off saving and investing for myself. BUT, I’m in my early thirties; experience has already taught me the wisdom of changing my mind–so I’m hesitant to say “never.”
You are wise beyond your years Froogal! Never is a risky thing to say.