Annuities Offer Steady Income, Big Drawbacks
Over the past two years, investors have been taken for a wild ride. Annuities offer a way off the roller coaster.
That, at least, is the marketing message of the insurance companies that offer an increasing array of annuity products. Independent financial advisers, however, warn that annuities are anything but a simple answer for investors in retirement.
Annuities can be structured many ways. With traditional, or fixed, annuities, investors buy an insurance policy that pays them a fixed amount of money each month or year until they die.
With variable annuities, your payout varies with market conditions.
Comparing With Mutual Funds
Variable annuities, then, provide little protection from the vagaries of the market. "A variable annuity is a mutual fund inside an insurance contract," says Warren Ward, a financial planner and head of Warren Ward Associates in Columbus, Ind. "I would rather use a mutual fund," he says, noting the fees and expenses are often much lower for mutual funds.
The one advantage of a variable annuity is it can provide tax benefits for certain users, though advisers warn that those benefits are often exaggerated by annuity sales pitches.
Fixed annuities offer a different set of risks and rewards. The key advantage of these products is they provide a steady income for the rest of your life. That insures you against market risk, the chance that the value of your investments fall, and longevity risk, the chance that you could live so long that you run out of retirement money.
One other solution to longevity risk is so-called longevity insurance. This is a fixed annuity that pays out only if you live long enough. The idea is to live on other retirement savings until age 85 or so. The annuity then provides you income for the rest of your life. Because not everyone lives to age 85, it's far cheaper than an annuity that starts paying income 20 years earlier.
Yet fixed annuities leave one big risk on the table: inflation. "If you take a fixed annuity, you're making a bet against inflation," says Thomas Muldowney, managing director at Savant Capital Management in Rockford, Ill.
A fixed annuity will pay you an agreed-on amount—$40,000 per year, for example—even if a rising cost of living decimates that $40,000's buying power. That's a problem when many predict "inflation will be a way of life for the next 30 years," Muldowney says.
TIAA-CREF, the third-largest provider of annuities in the U.S., advises using the products as just one part of a retirement portfolio. A fixed annuity "adds stability to your portfolio because it doesn't move with the stock or bond market," says Dan Keady, director of financial planning at TIAA-CREF. Retirees should annuitize enough so that guaranteed income covers basic expenses, he says, while having "a more flexible investment strategy for the remainder of your funds."
Financial advisers agree it can be reassuring to know you'll be getting a regular check in the mail. "Markets have been in turmoil," Ward says of the appeal of fixed annuities. "People are looking for security."
Locked In for the Long Term
What has limited the appeal of annuities is that they require investors to make a decision about their financial future that is difficult, sometimes impossible, to change later. "They're irreversible decisions, so you really ought to be careful what you're doing," says Don Martin, head of Mayflower Capital in Los Altos, Calif.
Ward and other advisers say now might be a bad time to make such a decision. While interest rates are at record lows, the rates of return on annuities are also quite low. By waiting for returns to come back to more normal levels, investors might lock in better terms, he says.
TIAA-CREF's Keady says investors can spread a few annuity purchases out over several years, rather than buying one large annuity policy at once. This reduces the risk that your entire annuity will be priced at rock-bottom interest rates, while also allowing you to adjust your retirement strategy to changing circumstances.
Will the Insurer Survive?
By buying an annuity, you're staking your financial future on the ability of one company to continue paying your income for decades to come. "The guarantee is no better than the company that issues the guarantee," Muldowney says.
States regulate insurance companies, and some states have funds that guarantee annuity payouts. Martin advises checking on the applicable state regulations, and also checking out an insurer's credit rating to gain confidence it will continue to survive.
The fees, commissions, and annual expenses associated with annuities can be bewildering, making it tough to decipher how much you're really paying. That's particularly true of variable annuities or other annuities with extra features and complicated options. "It seems like there is a cost every time you add a feature," Ward says. It's easier to do comparison shopping on a simple, fixed annuity.
Financial advisers warn that the process by which annuities are sold is anything but transparent or easy for inexperienced investors to navigate. Remember that the salesperson giving you advice is probably getting a hefty commission on each annuity sold.
"It's typically a case where you have an amateur buyer pitted against a professional salesperson," Muldowney says. "If that's the case, the amateur buyer typically doesn't have a chance."