Annuities are financial investments that entitle an investor to a fixed sum yearly, typically for the rest of their life. Intended to ensure against living a long time, an annuity removes the fear of running out of retirement savings.
Annuities Versus Stocks
There can be two camps when it comes to annuities versus the stock market for retirement income. The first camp believes that annuities are the best way to invest retirement savings for those who believe they will outlive their retirement savings. With many retirees living longer and longer in the world today, this may likely be true. The second camp believes that stocks are a much better investment than an annuity because of the rate of return. Typically, annuities take a large “chunk” of money and offer a smaller yearly payout.
The Breakdown of Annuities
For someone who doesn’t expect to live long past retirement, an annuity may not be a good option. In today’s annuity market, a 65-year-old man who pays $100,000 for a life annuity will receive $560 per month. This may seem like an extremely small payout, but when you consider that he will receive this amount, even if he lives to well over 100 years old, his 6.7% investment return seems like a smart move. For those who live long enough, their initial $100,000 will not only be paid back in full, but they will exceed that amount.
Why would an insurance company do this? Simple, most retirees will not live past the break-even point where the annuity enters the negative payout rate. The premiums paid by annuitants who don’t live long, in addition to the money made from bond investments, are the incentive for insurance companies to continue to offer annuities to clients.
Since annuities take a large initial investment, many people worry that if they purchase an annuity, then pass away before the break-even point is reached, their family will suffer. There is always this risk involved, and there are riders that can be purchased that guarantee some principal repayment to beneficiaries, but these riders are often expensive and not worth the extra cost.
Fear of Annuities
Those who fear annuities often think the same way about Social Security benefits. They will claim their benefits from Social Security as soon as possible, pointing out the same reason: payments stop when I die, so why not get them now?
Both Social Security and life annuities are not investments. Rather they are a type of insurance that decrease the risk of outliving retirement savings. Since death cannot be predicted, a person who purchases an annuity must go in with the understanding that they may not get all of their investment back.
Think of an annuity as you might car or home owner’s insurance. You purchase auto insurance in case you have an accident. You purchase home owner’s insurance in case of fire or flood. If you are lucky, you will never have to use either, but you have the peace of mind knowing that if you needed it, the coverage would be there.
For those who complain about car insurance rates because they have never had an accident, there is someone who is thankful that their car insurance covered their needs after an accident. The same is true for homeowners. Purchasing life annuities and delaying Social Security benefits both provide a benefit in exchange for an investment. When purchasing an annuity, you may do better or worse, but you will always negate the risk of running out of retirement money, no matter how long you live.
Some Famous Annuity Owners
There are some prominent public figures who have been noted for their use of annuities. These include:
- Benjamin Franklin – assisted the cities of Boston and Philadelphia
- Babe Ruth – avoided losses during the Great Depression
- O.J. Simpson – protected his income from lawsuits and creditors
- Ben Bernanke – disclosed in 2006 that his major financial assets were two annuities
Another Annuity Concern
Liquidity of investment money is another concern for many purchasers of annuities. Since the annuity takes a large sum of money that could be put toward other purchases, the purchaser does not have the flexibility or access to that money to cover large bills. They only have the yearly payout, albeit it for the rest of their life.
Alternatives to Annuities
For those who are still averse to tying up a large sum of money in an annuity, an alternative is to “self-annuitize” with a sustainable withdrawal rate (SWR). An SWR strategy works only for those who over-save before retirement. The funds in an SWR must be kept on hand to cut down on the risk of depleting a person’s savings. They are also needed to generate future income and to help during periods of recession when stocks do not generate a return. However, studies have shown that this retirement strategy is not economically viable.
If liquidity of assets is a concern, a retiree should consider that even if they decide to go with an alternative strategy, their savings may not be as liquid as they thought.
A Mixture of Annuities and Other Investments
A good solution for many is to mix annuities and investments. Annuities will allow retirees to invest more aggressively in their portfolio. With a solid income base of annuity income and Social Security benefits, market losses can be absorbed better and investors have a higher confidence level knowing that a portion of their income is secure.
Reasons to Purchase a Life Annuity
There are different perspectives on life annuities. Some of these include:
- The insurance has value even if the purchaser does not live to an old age
- Alternatives to annuities (“self-annuitize” methods) may not always have the liquidity they appear to have
- Annuity holders have a higher confidence level to invest more aggressively in the stock market
- Some retirees lack interest in investing and benefit from a set amount monthly
Purchasing an annuity comes down to personal preference and risk. No matter what a person chooses, as long as they are comfortable with their end choices, they have made the right choice.