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Using Annuities to Reduce Risk

When saving for retirement (and planning your spending in retirement), you have to plan for the possibility that your retirement will last for three decades or more. Of course, it might only last for one decade — in which case you deprived yourself throughout your life so that you could save three times the amount that you actually needed.

Pile that uncertainty on top of the uncertainty that comes from market risk and inflation risk, and you can see that retirement planning is a series of guesses. You have to plan for a financial-worst-case scenario in which you live well into your 90s, market returns are poor, and inflation is high.

And even if you do plan for that, you still can’t be absolutely sure that you saved enough.

So what’s the alternative?

Purchasing a single premium immediate fixed annuity with a portion of your portfolio.

Lifetime Annuities Eliminate Longevity Risk

In Moshe Milevsky and Alexandra Macqueen’s book Pensionize Your Nest Egg (my review here), they frequently describe annuities as “longevity insurance.” I like that description. It puts annuities in terms that most of us can understand.

For example, with homeowners insurance, we know that there’s a good chance that the money spent on the premium will go to waste. But, unless you can afford to “self-insure” (that is, unless you have enough money such that you’d be OK if your uninsured house burnt down), it’s still important to have.

Same thing goes for annuities: If you have so much money that you would be OK in the event that you live well into your 90s, market returns are poor, and inflation is high, then you don’t need to buy one. Otherwise, you probably should.

Eliminating Market Risk

In addition to protecting you from longevity risk, fixed annuities protect you from market risk. If you have a fixed annuity that, together with Social Security, provides enough income to cover your necessary expenses, you don’t have to worry about:

  • Poor stock market performance, or
  • An unfavorable sequence of stock market returns.

Your annuity will provide a steady payout no matter how the market is doing.

Eliminating Inflation Risk

Lastly, buying an inflation-adjusted annuity can protect you from inflation risk. (Though the inflation protection will significantly lower the initial payout.)

Remember, though, that if you really want to eliminate inflation risk, it’s important to get an annuity with a payout that’s linked to the Consumer Price Index (CPI) rather than one that increases at a fixed rate per year.  An annuity with a payout that increases at a flat 3% per year won’t protect you in the case of severe inflation.

Standard Caveats Apply

Despite how helpful annuities can be for retirement planning, they have their drawbacks:

  • They carry credit risk.
  • The money spent on the annuity will not go to your heirs when you die (unless you purchase a rider that allows it to do so, in which case the annuity’s payout is significantly decreased).
  • They’re not liquid. So, unlike other retirees, if you opt to annuitize a large portion of your portfolio, you’ll have to keep an “emergency fund” to use in the event of a large unexpected expense.

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Comments

  1. So when does, “Retirement Income Made Simple: Single Premium Immediate Annuities explained in 100 Pages or Less,” hit the shelves? 🙂

  2. Hehe. Working on it! It’s getting close…

  3. Be sure to include a chapter on Social Security “do-overs,” (a.k.a. buy-backs, or withdraw-repay-refile) They are the best SPIA deal in town!

  4. For real – you are writing a book on annuities? If you need a reader, send it my way.

    I liked this post, BTW! 🙂

  5. Hi Alexandra.

    Not a book on annuities as such, but annuities and their potential usefulness make up a significant portion of my upcoming book Can I Retire?. I suspect Dylan’s comment was in reference to that. Either that, or he’s poking fun at me because of how frequently I talk about annuities on the blog. 🙂

  6. I’m serious about a simple guide to SPIAs. How many books are available on investing, retirement, taxes, etc? And how many do you ever see that focus on SPIAs? As a financial planner, I’d love to have a go-to book for my clients to learn more about subjects like this on their own.

    Now that you mention it, when are you going to change the name of your blog to “Oblivious Annuitant?”

  7. Hmm, fair enough. Not a bad idea, I suppose. Though I’ll have to get this one out the door first. 🙂

    And, very funny. 😛

  8. Milevsky and Macqueen are writing for the Canadian market. How much of what they say must be adjusted/discarded for American readers?

  9. Other people’s opinions may vary, but I’d say, “not much.”

    There isn’t much in the book about tax planning or things of that nature. They talk some about the Canadian version of Social Security, but the way it fits into the overall analysis is the same.

    Also, they have different sources from which they can buy annuities than we do, but the products function identically as far as I can tell.

  10. As with ALL investing, annuities are a series of trade offs. You are substituting one risk for another [living a short life vs. living a long one]. I do not think that it is 100% accurate that buying an annuity protects you from market risk because the insurance companies are investing your premiums in the same market as you otherwise would be investing yourself. The losses are now the insurance company’s, for sure – unless they go bankrupt.

    You mention credit risk without going into detail. After the recent market plunge many insurance companies were weakened, along with everyone else, but the FIRE [Finance, Insurance, Real Estate] industries in particular . If you buy an annuity today you are betting that the selling insurance company will be around for as long as you live.

    Most advisors also suggest buying several smaller annuities, each under the guaranteed limits, and from different companies to spread the risk, perhaps laddered because of the low current payouts due to a low interest environment.

    Also, annuities tend to be expensive, with big front end commissions. Fortunately you can buy one direct from a few companies like Vanguard.
    This will not only save you a lot of money, it will save you from having to do business with non-fiduciary broker/salespeople.

  11. Jim: Regarding the elimination of market risk, my understanding is that when you purchase a fixed SPIA, the insurance company invests your money in bonds rather than stocks.

    And you’re right about credit risk. If you read the article I linked to above, it’s discussed in more detail. That’s one aspect of blogging that I think I’ll always struggle with–how much of each topic do you have to cover every single time you write about it?

    For example, not only did I give only a brief mention of credit risk, I didn’t even explain what an annuity is. Surely that’s important too. Is it sufficient to simply link to an article in which I explain that information? My hope is yes, because it gets rather tiresome to explain things over and over (and I imagine that it’s tiresome for subscribers to read such explanations over and over). But linking-in-lieu-of-explanation isn’t perfect because readers might not read the linked-to article.

  12. Many Thanks, Mike, I should have searched your site before I hit reply.
    The article link you sent me covered the cautions on annuities very well.

    I am familiar with the ideas of Milevsky, he is a great resource for alternate ideas/thinking on retirement. Another one is Zvi Bodie.

    If SOME of those insurance companies were not dipping [plunging?] into CDOs, mortgage backed securities, and other riskier-than-advertised derivatives I would be surprised. I’m currently reading Edward Chancellor’s excellent book, Devil Take the Hindmost: A History of Financial Speculation, and once one of these manias gets rolling it is hard for even the pros to resist [and investors are at least partly to fault for chasing returns and abandoning wise and moderate investments]. To be a contrarian fund manager you have to be able to resist the stampede of lemmings [and the outflow of their money].

  13. “If SOME of those insurance companies were not dipping [plunging?] into CDOs, mortgage backed securities, and other riskier-than-advertised derivatives I would be surprised.”

    Point taken. And I have precisely zero data either way myself.

    Also, I’d be interested in hearing your thoughts on that book when you’re finished. It’s on my to-read list.

  14. Annuities are a much maligned product but a simple instruments to fulfill a specific task. Though not for everyone. Also you gave to consider any fees before purchasing. Risk is still something to consider and I believe not addressed completely. You still have market risk if the invested instrument fails. Also if the company fails you stuck. If you live a long life and the Annuity company is solid, you win overall.

  15. Mike,

    Very good post. One question though: what is the optimal age to purchase a annuity?

    Deferred annuities are heavily pushed by insurance agents to people as young as 30 year old. Do you have any comment on the pros and cons of those?

    Michael

  16. Hi Michael.

    That’s a great question, and I don’t think I have any brilliant or concise answers.

    The younger a person is, the more an annuity will function like a simple bond (because there will be little/no “mortality credits” being earned). So, if you take the time to calculate the return that would have to be earned for it to make sense to delay annuitizing, it may be a very achievable return.

    Then there’s the question of interest rates. If rates are at historical lows, it may be a good idea for an investor to delay annuitizing when they otherwise might not.

    In addition, there’s the “let’s just be done with it” factor, which may lead a person (quite reasonably, in my opinion) to go ahead and annuitize earlier than might be mathematically optimal.

    Finally, it’s important to remember that a person doesn’t have to annuitize all at once.

  17. “Be done with it” has a certain amount of comfort to it, particularly if the younger, or healthier, partner in a couple buying a joint annuity is less comfortable with handling these transactions.

    A good plan is better than a plan that never gets implemented!

    I have read recommendations of around age 70 to buy a first SPIA, and to ladder several over a few years, up to perhaps age 80, always being careful of the limits to state insurance protection in case of provider failure, and to spread your purchases over different companies for the same reason.

    The logic behind this plan is that by age 70 you have a far better idea of what your health will be for the rest of your life than you do at age 30, or even 60.

    If you buy a first SPIA or deferred annuity at age 70 and your health deteriorates after a few years do not buy any more. Take a cruise or splurge instead.

    This plan, like dollar cost averaging, helps to level out the effects of interest rate changes.

    If you stay healthy, and can afford to live on the amount generated this way [the combination of Social Security, any pensions or other income, plus the payout from this first smaller annuity], any annuities bought later will also give a larger payout [your life expectancy is shrinking].
    This provides help with both inflation risk and longevity risk.

    This plan seems more flexible to me, and possibly [I have not run the numbers] a better deal than paying for expensive cost of living add-ons for annuities bought when you are younger – and the unknown variables are greater.

    The annuities being sold today are often complex and hard to compare.
    A salesman trying to make a generous commission will dazzle you with promises that you can get your money back in a few years, or get a COLA, or many other features. Just remember that complexity is your enemy and the salesman’s friend. Every feature you go for has a built in cost which eats into all your future payments and increases the commissions.

    As John Bogel says, “Costs matter!”.

  18. Mike,

    Jim’s comment pretty much sums up my recommendations to my clients. I think buying annuities at young age is like hedging a risk (longevity) that is not present at great costs and other types of risk.

    I have a client who is an life insurance/annuities wholesaler. He told me he would get 2% if his down-stream agent sells a 10-year deferred annuity, the agent himself will get 8%. So if some one purchases a $100k annuity, $10k of it will be out of the window at the moment he signs the contact.

    Most tellingly, this client of mine does not hold any annuities in his portfolio despite the fact he can get them at wholesale prices.

  19. I can top [bottom?] that story.

    A close friend who is a retired teacher and almost 80 lost her husband recently after many years of health problems. Between the two of them they had earned three government pensions [one each from city, state, federal] all with survivor benefits [hows THAT for diversification!?]. With two social security checks coming in until last month, and no debt, plus a life-long history of saving [the husband also worked until about age 78, four years ago], I would argue that they needed NO annuities, but since they were afraid of Wall Street they got an advisor/saleswoman from an insurance company to sell them about one $ million in annuities over the past couple years [all this money came from taxable savings and from supplemental retirement accounts including IRAs, a 403-b, and the low cost Federal Employees Retirement Thrift Plan].

    The most recent visit from the saleswoman, supposedly “just to change the names” on the annuities [take off the husband, add the two sons] ended up [despite my plea to my friend to make NO changes right away] with the sale of yet another NEW annuity on the ONE week anniversary of the husband’s funeral.

    To some folks, any offer to “help” means “help themselves”!

    I am also wondering if the transfer/name changes on the OLD annuities did not involve a new commission[s]. I do their taxes but can not [do not want to] act as their advisor due to our friendship, and I also do not feel qualified.

    My friend is a bright and wonderful person who is also my mom’s age.
    She is still not thinking straight due to all the recent developments [she also helps care for her 103 year old mother, so I hope she has the last laugh on the insurance companies!].

    This saleswoman’s recent behavior should be illegal in my opinion.

    This is yet another example of a non-fiduciary advisor who just can not resist taking another bite of the apple, no matter what is in the best interest of the client. A disgrace to the profession! A disgrace to the human race!! People who prey on old folks are beneath contempt!!!

  20. Jim,

    Sadly this is happening every day. Judging from what you wrote here, you are certainly qualified to give advices.

    There are two things you can do for your friends,

    1) refer them to Allan Roth’s articles about annuities for their own education, like this one
    http://moneywatch.bnet.com/investing/blog/irrational-investor/investment-tricks-annuity-style/1899/

    2) help them find a fee-only financial planner.

  21. Michael Zhuang

    Many thanks for your reply! I also enjoy all your articles and newsletters!

    After my friend has had a chance to grieve, I will try to talk to her, perhaps in connection with preparing her taxes early next year. She has
    told me several times over the past couple years that she did not want any more annuities, but still buys another one with every yearly “review” visit from the young and smart saleswoman.

    There are [as usual!] a lot of family dynamics involved.

    Neither son got along with the father. One is an auditor, the other ran his own business [now failed]. The father/husband worked as an auditor until age 78, when he got sick 4 years ago. Now, I am just a laid-off programmer who never completed his MBA, but I have been doing the parents’ taxes [using TurboTax] for the past four years [I think that explains matters well enough!].

    I feel better being able to discuss these issues here without betraying confidences. I feel like a witness to a robbery, but hold my tongue because I understand how tricky it is to help our parents or their peers. There is a great deal of emotion, feelings of losing power, vulnerability. Many elderly never report financial crimes against them because they are embarrassed that their trust was not well placed.

    The issues are never just black and white either. My friends’ extreme aversion to paying taxes helped make them suckers. I spoke to the advisor after they rolled their CDs [incurring major early withdrawal penalties!] from taxable accounts into some of the first annuities they bought, and she told me that “some of her clients”, if offered a free $100 with the proviso that they have to give someone else [the government] half, will turn down the $100.

    I don’t think my friend understands the tax implications of annuities even today. The promised “tax free” part of your annuity payments is a return of part of your principle! There is NO magic! I have a different friend who was being sold a SPIA as having a “6% return” and had to explain to her that most of the “return” was a partial return of her own money.

    Regards,

    Jim

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