Key Considerations About Including Annuities as Part of Your Retirement Plan
Many of us have heard of annuities but few understand how they work and if they should be part of your retirement plan. I’ll explain.
What is an annuity?
An annuity is a pension plan you purchase from an insurance company, rather than one you receive from a past employer or Social Security. You may have heard of other more complex annuities but I am only addressing the simplest and most useful kind, which is generally known as a single-premium immediate annuity. Forget about complicated variable annuities and annuities that are attached to whole-life insurance plans — they’re for the salesperson’s benefit, not yours.
Think of an annuity as the opposite of term life insurance. With life insurance, you periodically pay a premium and in return, your beneficiary receives a lump-sum payment when you die. With an annuity, you make an upfront lump-sum payment and in return, you receive monthly pay-outs until you die.
When an insurance company sells you life insurance, they hope you live forever; with annuities, the insurance company “hopes” for your quick death.
Annuities are best thought of as longevity insurance. You “bet” that you will live a long life and if you do, you will receive more than you originally paid. As I suggested, the insurance company “bets” on you living a short life so its profit is maximized.
What else should you consider?
You can choose to have these payments be inflation-adjusted or have a survivor-benefit (i.e, continue to be paid to your spouse if you die first), but these features are more costly — either in the form of a higher up-front payment, or reduced monthly benefits.
You can purchase annuities with pre-tax IRA funds and this is known as a qualified lifetime annuity contract or QLAC. You can also opt to delay the start of the payments until years later and this will reduce the required minimum distributions that you are required to take from your IRA during this deferral period. If you are considering an annuity purchase, a deferred QLAC may be your best option as it will reduce your RMDs during the early years of your retirement.
One last consideration is that annuities are not guaranteed in a manner similar to how FDIC insurance protects bank deposits. If the insurance company were to go bankrupt, your future payments would be at risk. Yes, there are state guaranty pools that may provide some protection but you don’t want to test them and find out how solid they are. This is a structural defect with annuities and one reason why you should not annuitize all of your savings.
How are annuities priced?
Pricing for single premium immediate annuities (the type I’m discussing and recommending) is straightforward. You only need to focus on a single dimension called the payout ratio. This is the percentage of the amount you paid for the annuity that is repaid to you each year. (More typically, you would opt for a monthly payment and would receive 1/12 of this payout ratio each month.) This is not the same as the implied investment rate of return.
The payout ratio is based on your age, the current level of interest rates, and your gender. Men have shorter life expectancies so receive a slightly higher payout ratio than women.
For example, the payout ratio for a 70 year old purchasing an immediate annuity is currently ~7.4%. This simply means that if you purchased an annuity for $100,000, you would receive annual payments of $7,400, or monthly payments of ~$617. These would last until your death.
You would need to live more than 14 years to have been paid back the full amount of your annuity purchase (and longer, if you include the foregone interest). As you can see, annuities make good sense if your life expectancy is longer than average.
Who should consider an annuity purchase?
You should not buy an annuity if you:
- are still working. Don’t buy them as an “investment” at an earlier stage of life or as part of a whole-life insurance plan. Retirement age is the time to consider this.
- receive a significant pension from another source, perhaps in addition to Social Security. An annuity is probably redundant as you already have a guaranteed source of income.
- believe you have a shorter than average life expectancy.
You should consider an annuity if you are entering retirement age and would like to:
- have “longevity insurance” to ensure you don’t outlive your money.
- receive guaranteed income beyond your Social Security benefit.
- reduce your required IRA distributions in the early years of your retirement.
- diversify your retirement assets beyond just your savings.
Don’t think of an annuity as an investment as it won’t make financial sense; it’s insurance, similar to auto or life insurance. In this case, you’re insuring against a long life.
Do you have questions about whether an annuity makes sense for you? Get in touch to find out about my Retirement-Readiness service.