Annuities: The Baited Trap

Critical Stuff: Annuities are expensive and unsuited for most retirement savings.

In This Chapter: Fire the bugger. Betting on dying.

Annuities look like the perfect retirement investment. You get a higher payout than you could with most other investments and you are guaranteed a return. There are numerous flavors of annuities so you can choose the one that’s right for you. In most cases, an annuity grows tax-free. What could be wrong?

In a word: Everything. Actually, the number of people that annuities make sense for is tiny, and they can be devastating for your retirement goals.

Lots of books on retirement simply say don’t get an annuity. I think that’s an oversimplification and inadequate advice. But you need to be very careful in considering one, and you have to do a lot of work to understand what you’re getting into. The biggest problem with an annuity is that it can be very hard or impossible to extract yourself from one if you find it’s a bad choice. There are many rules and conditions, many hidden charges and expenses. Many ways the insurance companies make certain that your annuity is good for them.

Furthermore, the larger payout from an annuity comes from deductions from the principal. If you are taking out six percent per year, and the insurance company is taking four percent, your basis could be dropping by ten percent per year on a year that the stock market is flat,  Years when the market tanks are just as devastating to your annuity as it is to any other market investment.  Your six percent payout in the next year will be on that lower principal.

If your advisor tries to push you into an annuity without ensuring that you understand every aspect, then you’re working with the wrong advisor, because the first thing you need to know is that investment advisors collect a huge commission for selling you an annuity. Where do you suppose that money comes from? If you add up all the costs (and good luck figuring that out, annuity contracts are purposely complex) you might be paying four percent or more for an indexed annuity with guarantee riders. That means over the course of the investment, the insurance company will collect between 30 to 60 percent of the return on the investment. And you are NOT protected from downturns in the market! The guaranteed return ensures that your payout on the principal will be a specified percentage, but the market value of the principal can, and often does decline. Your “guaranteed” payout may (and probably will be) be on a declining basis.

So if your financial planner tries to get you to buy variable annuities or equity-indexed annuities, fire them on the spot. Seriously. They’re just an insurance salesman in drag. A Single Premium Immediate Annuity makes some sense for some people because it’s a pure insurance product that provides protection against outliving your savings. The amount it pays out is greater than the market interest for two reasons:

  • You are drawing down the principal, not just living on interest.
  • The insurance company is betting on you dying on schedule–which people do on average. The more annuities they sell, The safer the bet is.

I’m a little surprised that some enterprising insurance company hasn’t created a SPIA for people who smoke, drink to excess, are fat, and don’t exercise. They could offer a very attractive payout rate.

You can consider a SPIA to be equivalent to having a defined benefit pension–because it is. It pays you, and perhaps a joint annuitant such as your spouse, an income for as long as you live. Beyond that there are no survivorship benefits, your heirs don’t get anything. That’s how the annuity is able to pay you better than market rate. There are other plans that offer some survivorship benefits, but they necessarily pay out less money to you. It probably makes more sense to establish a SPIA to cover your basic expenses use the rest of your investments for estate planning and supplemental income. The real litmus test for considering an annuity is the adequacy of your overall portfolio. If you can support yourself entirely from the interest and dividends of your portfolio, then a SPIA is probably not necessary. But if you think there’s a good chance you’ll outlive your portfolio, then it’s worth considering.

A SPIA is a contract with an insurance company, and so there is some risk if the insurance carrier fails. You can mitigate the risk by spreading out your annuity with several carriers, and there is somewhat of a safety net in the form of state guaranty associations. But make sure you’re picking the most stable companies for annuities. A lot can happen in thirty years.

The Bogleheads Guide to Retirement Planning has a succinct chart that’s excellent for considering annuities. This is a lightly edited version.

In Favor                                                                          
Low retirement savings                                                                
High retirement savings
Not concerned with estate                                                            
Estate is important
Concerned about financial independence        
Willing to accept help late in life
Risk averse          
Risk tolerant
Older age            
Younger Age
Willing to irrevocably commit money            
unwilling to lose control of money
Willing to trust insurance company              
Skeptical about insurance companies
Expect 10 year treasuries to fall                      
Expect 10 year treasuries to rise
Main concern: How much do I get per month      
Main concern: How much do I get over my lifetime



The Retirement Trap Copyright © by Bill Babcock and Babcock, William. All Rights Reserved.

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