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INCOME ANNUITIES ARE a simple, cost-efficient way to generate guaranteed retirement income, and yet they account for just 5% of overall annuity sales. My contention: They can play a unique role in a portfolio—and deserve serious consideration by anyone planning for retirement.
When most people hear the word “annuity,” they cringe, and rightfully so. Over 95% of the annuity market is made up of tax-deferred variable and fixed annuities—investment products that are often complicated and expensive. But don’t let the word “annuity” scare you away from income annuities.
Why not? In retirement, there are three key financial risks we all face:
An income annuity is one of the few financial products that can address all three risks. With a lifetime income annuity, you pay a lump sum to an insurance company in exchange for monthly “annuity payments.” Like pension payments, annuity payments are guaranteed for life, no matter how long you live or what happens in the financial markets. Typically, income annuities come in two varieties, immediate (payments start right away) or deferred (payments start in the future). You can also include an “inflation rider” with your annuity, which increases your annuity payment annually and helps to offset future inflation.
In addition to reducing financial risk, income annuities can provide competitive returns. Based on recent quotes from A-rated insurers, a 65-year-old man investing $100,000 in an income annuity would receive $554 per month and a 65-year-old woman would receive $510 per month. (Because women tend to live longer, they receive a slightly lower payment.) These amounts are the equivalent of 6.6% and 6.1% annual withdrawal rates, respectively. Assuming you live to the average life expectancy of 85, these income rates roughly equal the return on high-quality corporate bonds. That’s not bad, given that the annuity payments are guaranteed to continue, even if you live far longer.
Some retort that the return from income annuities is nowhere near long-term stock market returns. That’s true. But beating the stock market isn’t what income annuities are built for. Rather, income annuities are designed to provide a guaranteed paycheck that protects you from longevity risk and gives you an attractive, risk-adjusted return on your investment—and they do that job very well. On top of this, income annuities are simple to understand and require limited, if any, management in retirement—something that becomes more appealing as retirees get into their 80s and 90s.
What’s the catch? You give up upside. While your annuity payments won’t go down if the financial markets tank, they also won’t go up if the markets do well. You also give up liquidity. Once you purchase an income annuity, you’re locked in and can’t change your mind. Another consideration is the “early death” risk. With a traditional income annuity, the payments stop upon death, so you would lose 100% of your investment if you died the day after buying an income annuity. In exchange for reducing your annuity payment by 5% to 10%, most insurers will give you a “return of premium” benefit that guarantees that you—or you and your heirs—get back payments equal to at least your original investment. A good deal? For the record, I prefer to take the risk of an early death and go for maximum retirement income.
Here are four recommendations for anyone thinking about an income annuity:
1. Treat them as a lower risk, lower return asset—similar to bonds. When settling on your retirement portfolio’s asset allocation, your income annuities and bonds should be balanced with stocks and other assets that can deliver long-run growth.
2. Most people shouldn’t allocate more than 30% of their portfolio to income annuities. That way, you’ll still have a sizable buffer of assets to support unexpected expenses and to generate growth.
3. Consider buying income annuities over time, starting 10 to 15 years before retirement. Like bonds, the cost of income annuities changes as interest rates change. Buying income annuities over time can help you average your cost over interest rate cycles, similar to dollar-cost averaging with mutual funds.
4. Buy early, but not too early. We’ve seen some firms marketing income annuities to individuals in their 20s and 30s as a way to build their own pension. At this age, you really need growth and liquidity, which is the opposite of what income annuities offer. It’s best to stick with stocks and bonds when you’re far from retirement, and then average into income annuities as you get closer.
Dennis Ho is a life actuary who has spent more than two decades in the insurance industry in a variety of actuarial, finance and business roles. He can be reached at dennis@saturdayinsurance.com or via LinkedIn.
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In a world where the ten year note pays 2.06% and the thirty year bond pays 2.57%, an insurer paying 6.5% is losing 4-4.5% right off the bat for a policy written for a 65 year old. If the median longevity is twenty or so years after that, what obligation does the insurer buy to balance off the annuity? How does the insurer make money? By projecting that enough people die before the median that they come out ahead?
Hi – thanks for the question. The 6.5% isn’t actually all interest – its a combination of interest + return of principal. Remember, at the end of the annuity you don’t get principal back like a bond. On average, a 65 year old will live 20 years and insurers end up crediting roughly the yield on AA-rated corporate bonds. Since they invest in a range of assets, they earn a bit more than that and use the difference to cover their expenses and profit margin. Insurers generally don’t aim to make money on the longevity component here, so funds from people who die early usually go to offset people who live longer. Hope that helps, and let me know if you need any more detail.
Thanks Dennis! I’m an RIA and I have never recommended annuities. I could never understand why an annuity would be preferable to laddered CD’s. I have a client who is a 56 year old widow which this might make sense for. I’ll go to your site tomorrow to learn more.
Dennis, thanks for a straightforward introduction to the puts and takes of annuities. It’s been an important realization for me that annuities are not investments. They are insurance against living longer than expected and running out of money. I fully expect to wander into somebody’s figurative office sometime perhaps 15 years from now and buy a Single Premium Deferred Annuity for my wife and I, to protect against that very thing. By that time sequence of returns should be a lesser risk to our retirement portfolio, and as I understand it, I will benefit both from the lower cost (vs an immediate annuity) but also it doesn’t pay out until near that point in time where I expect we may need it.
Thank you for the note and I’m glad the article was helpful. Using deferred annuities is a very sound strategy and likely the one I’ll use when I get to retirement age. The one thing I’d suggest is just remember to factor in inflation when you’re figuring out how much income you need your deferred annuity to pay out initially – its easy to forget about since the transaction happens today but payments don’t start for years. Good luck!
Sounds like an ad for annuities. I am the beneficiary of an annuity. The principle grows until you start taking payments. Then the payment amount is determined based on the value with no additional appreciation. My Mother bought a single premium annuity for $10,000. It grew to about $14,000 when she started taking payments over 10 years. $14000/120 months = $117/mo. For the next few years my sister and I each get about $58/mo. NO increases during the payout period.