Do You Need an Annuity?

Annuities are like religion and politics - which are best when not discussed in polite company. Most financial advisors can be found on one side or another of a wide divide. Some advisors love the annuities and all the complex bells and whistles that add flash to the product (and make them difficult to understand). Other advisors hate annuities for being too expensive, over-hyped products that pay good salesman far too much money to incent them to lock unwary investors into these products (for life). For the record, I'm in the latter camp.

But even in my skeptical view, annuities have their place. (For more about annuities, check out this Morningstar article.)

Annuities will be the solution of choice for many retirees who have saved up some money, but not enough to truly provide them with financial security for life. These folks are at risk of outliving their financial resources, and for them it may make sense to transfer this risk to an insurance company which can afford to spread it around. For these people, an “immediate annuity” is worth considering. This investment will assure a certain amount of money for life. For a couple, a “joint annuity” will pay out until the second spouse dies. If the couple is killed in a car wreck on the way home from buying the annuity, bad news for them (but they won’t be around to complain). However, in the event that they have inherited good genes and live to be 105, it is the insurance company who takes it on the chin. For those with limited retirement funds, outliving your resources can be a sad end to an otherwise noble life. To me, it makes sense to insure against the “risk” of living too long, even if it means that an insurance company will receive a windfall if something happens to you in the near future.

As an example, an internet-based web calculator estimated that a joint life annuity for a 72 year-old male and his 74 year-old spouse will pay a 7.7% yield. This is far above what’s available in the bond market, but you would expect it to be because part of that income stream is return of principal. It’s an apples and oranges comparison to a 10-year bond at 4.87%. On a $200,000 portfolio, that would provide a payout of $15,400 annually. By way of contrast, many financial planners will tell you that tapping your portfolio for more than 4% annually (which provides only $8,000 per year) leaves investors at risk of outliving their resources if markets head south for a protracted period of time.

True, the comparison is patently unfair. At the end of most normal periods, the normal portfolio will still have money in it which can be passed on to the next generation. That’s why, for many, an annuity is inappropriate. But consider the downside in each scenario for a retiree of limited means. With an annuity, the downside is that maybe the kids don’t inherit as much. What did they do to earn it? With a normal portfolio of stocks and bonds, the downside is that the investor lives too long and ends up living with their offspring (providing that’s even an option). For many, the higher current income and worst case scenario with an annuity are preferable to the risk of outliving their resources and being without any resources at the end of life.

The other person who may want to consider an annuity is on the other end of the economic spectrum. If you happen to be one of the lucky few who is young and making more money than you can fit into your retirement plan, annuities provide a tax-deferred saving vehicle. Because they are more expensive than normal mutual funds, the money needs to remain in them for awhile (sometimes nearly 20 years!) before the benefit of tax deferral will offset the high fees of many annuity products. And keep in mind that money comes out as ordinary income instead of capital gains, and currently is taxed at a relatively high rate. But if you’ve maxed out your IRA and your 401(k) and there is still a need to build up the retirement nestegg, then annuities could provide some tax shelter. Take a professional athlete who has high earnings potential while he or she is young, but uncertain earnings power after retirement. They might be an excellent candidate to consider an annuity for all or a portion of their retirement planning needs.

If you don’t fit into either of these categories, feel free to shop for an annuity, but caveat emptor (buyer beware!). I’ve seen IRA’s put into annuities, where the tax deferral is unnecessary (IRA’s are already tax deferred vehicles, and have much lower expense ratios) and it would seem that advisor commissions, rather than common sense, drove the decision.

Also beware of the bells and whistles. Most bells and whistles are like fins on a 1950 Buick. They are there to sell the car, and have little real utility. By offering unique riders and options, annuity salesmen take themselves out of the commodity market – where returns can be compared – and put themselves in the arena where special features make comparison shopping impossible, and the commissions on these products are much higher. Sales commissions on annuities can be as high as 7% - 10% of the face value, and salesmen who have no shame love the complexity of these products.

Most investors ought to avoid the bells and whistles that make the products sound sexy. If you need to transfer the risk of outliving your resources to an insurance company, take a look. If you need a larger tax deferred retirement nestegg than you can stash away in your IRA and 401(k), then consider an annuity. Otherwise, take a look but be skeptical of the promises you hear.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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