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Annuities for the “Yacht-less”

Annuities for the “Yacht-less”

There is a lot of advertising for annuities today.  Many people feel a little skeptical about these financial products. Be warned: This topic can be a little dry, so let me say at the outset that this blog post is most relevant for those near or in retirement. Here we go: “Are annuities a good idea for you?”

Before we continue, please let me emphasize that I’m a fiduciary fee-only financial advisor, which means I do not receive commissions directly or indirectly on the sale of a financial product. As a fiduciary, I put my client’s needs first, always.  Also, this blog post is not a recommendation to buy or sell an annuity; rather, it is an outline of my approach to annuities, and the things to consider when evaluating them.  As always, before purchasing any investment or insurance product, be sure to do your own due diligence and consult a properly licensed professional should you have specific questions as they relate to your individual circumstances.

“Annuity,” sounds like a math test topic

It turns out that people are living longer these days, so a concern retirees often have is “Will I outlive my income?” This is known as a longevity risk. An annuity is a financial product that addresses longevity risk.  The insurance company agrees to pays a cash-flow to the annuity owner contingent on the owner surviving, and therefore provides the owner with a hedge against longevity risk. In other words, the annuity keeps paying until the owner passes. 

Vanguard defines an annuity as “a financial product typically used by investors to save tax deferred for retirement or to generate regular income payments, helping to replace a paycheck in retirement.  They are insurance contracts whose payments are guaranteed by the company issuing the contract[1]”. The most common annuity product is an immediate-pay fixed annuity[2]. Other types of annuities, such as “variable annuities” and “equity-indexed annuities”, also address longevity risk.  But they add complex features that are costly to the investor, including the “death benefit” (morbid, isn’t it?). I prefer simplicity to complexity. 

Immediate fixed annuities provide a steady income stream for life, thereby helping to solve the problem of longevity risk.[3] “The older you get the more valuable it is to hedge longevity risk and buy an annuity….  As we age the uncertainty of our remaining expected life span declines, and the value of insuring against longevity risk increases.  So, if you can, it pays to wait before buying an annuity. It gets cheaper and more valuable as time goes on.[4]”  Along with longevity comes medical expense risk in our later years and the prospect of significant Long-Term Care (LTC) costs.  Two thirds of 65-year-olds will never enter a nursing home, but for those that do the expenses can be significant[5].

My focus here is on immediate-pay fixed annuity.  I’m not in favor of bundling insurance products with investment products, as evaluating them is made more difficult and the fees charged on these products can be significant.  There are three main kinds of annuity products: Fixed Annuity, Variable Annuity and an Indexed Annuity. Please see the APPENDIX for a brief description of each.

Taxation and Annuities

An annuity contract allows for additional tax-deferred retirement savings as the annuity owner’s investment grows tax free[6].  Annuity income, when received, is assessed as ordinary income for tax purposes, and the owner receives a deduction for a proportion of their investment each year, i.e. the cost of the annuity.  The IRS has a formula for working this out.

For example:

Annuity contract cost                                                                                  $120,000

Tax multiple for 65-year-old[7]                                                                 20 

Amount of annuity payment excluded from tax ($120,000 /20)            $6,000

                                               

When and why should I purchase an annuity?

I do not consider an annuity to be a total solution for your retirement income. Rather, it can represent a component of your retirement income and  investment portfolio along with social security, taxable investments, deferred tax investments (401(k), IRA, Roth IRA), home equity, business interest equity, and other sources of income such as a rental property. 

So, what should you consider when determining if an annuity is relevant for you?

  • You have good health and a family history of longevity.[8]
  • You are near or in retirement.
  • Your financial plan suggests you need some “no effort” regular income and a regular check is important for your peace of mind.
  • You have a concern about the volatility of the equity market, and just rather not deal too much with that.[9]
  • Leaving a legacy is important, but sufficient income to live independently and with dignity in retirement is your priority.
  • Maximizing long-term growth of your investments is not a priority.

If you were to purchase an annuity product it would represent a component of your portfolio’s fixed income; as a result, it can place a limitation to portfolio rebalancing in the future.  Keep in mind that a fixed annuity is just that, fixed, there are no increases in payments to take account of inflation, which is a key risk for a retiree (there are annuity products that address this, but you will receive less). You can do some shopping on immediate pay annuities by visiting www.immediateannuities.com/  This website will also give you price quotes and the credit ratings for each quoting insurance company.  Thankfully, you will not receive a sales call after visiting this site, and if like me you’ll receive documents in the mail within a few days.

Conclusion – Focus on what you can control.

If you decide to include an annuity in your investments and financial plan, be sure to ask yourself the following: Does my financial plan fit my needs and my risk tolerance? Does my financial plan adequately provide for dimensions of return (equity and fixed income)?  Are my investments diversified, and ideally globally?  Are all expenses and taxes known and managed? And, will the plan keep me disciplined through market swings and dips (we want to avoid capitulation)? For some people annuities won't make sense in their portfolio, but for others they can be a good fit. As always, get objective and independent advice before purchasing an annuity.

Any questions about annuities?

I hope you found this blog post helpful and that it steers you towards the best option for your needs.  Each week I allocate time to answering questions I receive on my posts, so if you have questions, please let me know at This email address is being protected from spambots. You need JavaScript enabled to view it..  I do my best to get back to you within 48 hours.   Please feel free to share this post via Facebook or LinkedIn with anyone you think will benefit from it.

APPENDIX

Three main types of annuities that suit a variety of needs, goals, and budget.

Fixed Annuity

A fixed annuity is the most straight forward. You make a payment or a series of payments, and the insurance company promises you a minimum rate of interest and a fixed amount of periodic payments in return.

Variable Annuity

A variable annuity is similar to a fixed one in that you make a payment or a series of payments.

However, rather than offering a fixed amount in return, with a variable annuity you decide where to invest your money. The annuity pays you a level of income in retirement that is determined by the performance of your investment choices.  Because you’re in control, you can tailor your investments to your level of risk tolerance.  

Indexed Annuity

An indexed annuity combines the features of a security and an insurance product in one. With it, your payment contains a promised return that, rather than being based on investments you choose, or on a fixed rate, is based on a stock market index, such as the Standard & Poor’s 500 Index.


[1] Product guarantees are subject to the claims-paying ability of the issuing insurance companies.  A way to protect against this would be to diversify annuity contracts with several insurance companies.

[2] Sometimes called fixed, or fixed income annuity.

[3] Investing for a Lifetime.  Managing wealth for the “New Normal”: page 219  Richard C. Marston PhD, 2014

[4] The New Wealth Management, 2011 CFO Institute. Wiley. p 295.

[5] Amy Finkelstein “The Market for Long Term Care” in The Future of Life-Cycle Saving and /Investing: The Retirement Phase: (Charlottesville, VA: Research foundation of CFA Institute, 2009)

[6] The annuity is in addition to any IRA or 401(k) contributions, which have annual contribution limits.

[7] Life Expectancy Table from IRS Publication 939

[8] A website I refer clients to get an idea of their expected longevity is www.livingto100.com

[9] Having a proportion of your investment portfolio in the equity market is an important hedge against inflation, as most immediate annuities leave the investor with inflation risk.

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