Previous post:

Next post:

Should annuities be a part of your retirement plan?

by retirebyforty on February 27, 2013 · 29 comments

in retirement

Who need annuities? I used to think that I’d rather invest our retirement portfolio and just live off the income, but with the recent volatility, I’m taking a second look at annuities.

Annuities can be an important part of retirement if you don’t have a pension. Here is how an annuity works. You give the insurance company a lump sum payment in exchange for a guaranteed monthly payment for the rest of your life. This might be a good way to go if you don’t have a pension and you want the peace of mind that comes with a guaranteed minimal income. I’m just looking at an immediate annuity for now.

Lately, I have been thinking about an annuity as a part of our retirement income portfolio. Previously, I didn’t like annuities because I always thought I could do better with stock and bonds. However, an annuity has one big advantage over stocks and bonds which is guaranteed income (as long as the insurance company stays in business.) The stock market has been volatile and I wouldn’t want to depend on it too much in retirement. Bonds have very low interest right now and they are riskier than annuities.

who need annuities?

How much annuity to buy?

This is a difficult question to answer if you are not near retirement. You need to figure out your retirement income and yearly expense. Our full retirement date is still out 25 years so it is pretty much impossible to figure out our retirement income at this point. We’ll just take a guess and see what happens.

Retirement Income

  • Social security income – Social security income is the biggest question for us. The Old-Age and Survivors Insurance and Disability Insurance (OASDI) Trust Funds is projected to run out in 2038. Social security would be able to pay only 73% of scheduled benefit in 2039. My social security benefit projection is around $2,000 and Mrs. RB40’s benefit is about the same. We’ll assume 60% of $4,000 to be conservative. Social security income = $2,400.
  • Pension – We’ll assume no pension.
  • Passive income – All our passive income is from rental properties, dividend stocks, bonds, and peer to peer lending right now. For this article, let’s assume we liquidated everything right before retirement for a lump sum.
  • Active income – We’ll assume no active income

Expenses

Our average monthly expense from 2012 was $3,420. This is a comfortable level of spending and we can probably function on less if we need to. However, let’s stick with this to see how our calculation ends up.

How much would it cost?

From above, we have a short fall of $1,020/month and the annuity can fill that gap. I plugged this into an annuity calculator and the cost for joint life income came out to $219,196. Joint life means we’ll receive payment until both of us pass away. That’s a lot of money to hand over to an insurance company at one time.

*You should buy annuities from several insurance companies so you don’t put all your eggs in one basket.

Too early to call

This whole exercise seems a bit pointless when we still have 25 years left until full retirement. There are just so many things that can happen in 25 years.

  • Social security might get a reform and we might get 100% of our benefit (yeah, right…)
  • Mrs. RB40 might qualify for a pension at some point.
  • We might move to a lower cost location.
  • Our expenses would probably increase due to healthcare.
  • Our mortgage would be paid off at some point and our monthly expense will be reduced.

It’s still a good exercise though. It gave me an idea of how much an annuity would cost in comparison to our assets. I could trade in our dividend portfolio for an annuity and wouldn’t have to worry about minimum income for the rest of my life. At least we’ll have enough for food and rent with social security + annuity. Of course, depending on social security might be a bit foolish too. We’ll just have to see what happens to social security in 25 years.

After trading in our dividend portfolio, we would still have our retirement portfolio and rental properties. We could trade in all that in for a 60/40 stock/bond portfolio and withdraw 4% every year. At that point, volatility wouldn’t bother me much because we’d have enough money to cover the basics. Any income from the rest of our portfolio can be our fun money.

Anyway, the most important thing about retirement saving is to invest early and consistently.

 What do you think about annuities? I would love to get some input from people who are a bit older. I’m pretty sure my risk tolerance would be much lower when I’m 65.

{ 26 comments… read them below or add one }

My Financial Independence Journey February 27, 2013 at 2:55 am

Annuities are an investment class that I’m still leery of. I’m not entirely convinced that an insurance company could really invest my money any better than I could.

I would never trade in my dividend growth portfolio for an annuity. Although I might consider an annuity in addition to my existing portfolio, kind of as a way to gaurantee some minimum level of income. But there may be other options to achieve that goal as well.

Reply

retirebyforty February 27, 2013 at 2:10 pm

As I understand, they put it in bonds. The reason why they can pay out more than bonds is because of people who check out early. I forgot what else, but there is another reason why they can pay back more than bonds.
I love the dividend growth portfolio too, but it is a lot more risky than annuities.

Reply

jim March 1, 2013 at 3:22 pm

“invest my money”

With fixed immediate annuities you don’t have an investment balance and your money isn’t invested for you. Thats not how it works. You have a contract with the insurance company and they’ll pay you money every month. Thats the end of it. The insurance company can do whatever they feel best with THEIR money that you paid them to buy the annuity. Even when you buy an indexed annuity that is tied to a stock market you still don’t have money sitting in an account and the insurance company probably doesn’t even buy stock with your money. They more likely just buy some options to hedge / model the stock index performance. Or they may not even do that.

How well the insurance company invests doesn’t directly impact your annuity if its a fixed immediate annuity. The only risk there is that the insurance company might go bankrupt. Insurers rarely fail and when they do theres state guarantee associations that back annuity and life insurance policies (vaguely similar to FDIC).

e.g. If I buy a fixed annuity from New York LIfe, I might pay them $100,000 at age 65 and they might promise to pay me $550 a month for the rest of my life. NYL then takes that $100k and does what they see fit with it. I no longer have $100k and I hve no investment balance with them. I have a promise that NYL will pay me $550 a month till I die and nothing else. If NYL gambles on hog futures and loses half their money and takes a giant quarterly loss because of it that doesn’t change my annuity at all and they still owe me $550 a month. If NYL buys tulips and quadruples their money and has a massive profit that doesn’t change anything about my annuity. How NYl handles their money has no impact on my $550 contract. THe only worry is if NYL goes bankrupt, then the state guarantee would step in to back the annuity. Or more likely another insurer would buy NYL’s assets & liabilities at a discount and take over my annuity.

Reply

Luke-1776 February 27, 2013 at 5:56 am

Given the various types of annuities that each serve a specific purpose, please be sure to spend some time learning about the pros and cons of each class before making a decision for or against them. Remember, annuities are a form of insurance (protection from outliving your assets)… and just like anything, never put all of your eggs in one basket.

Reply

SavoirFaire February 27, 2013 at 6:35 am

I too am a bit apprehensive about an annuity. Spreading it around makes sense if you did go that route though. I would definitely not put a substantial amount of my portfolio in this type financial asset. Most advisers seem to advise against them.

This is a similar argument regarding life insurance. I went with a whole life plan, which I know many do not like. However after paying into it for 20yrs (I started it very young on the advice of my father), I am now done paying into it and it has both a growing value as well as a death payout. I can take the extra out anytime I want without penalty the payout value remains, or leave it as a larger sum for any heirs. I know in another post you talked about term vs whole and the only thing you did not take into account was funeral expenses. Even if you have no debt someone still has to pay for your funeral so a small whole life is not a bad investment. Why should the loved ones you leave behind have to pay out of pocket for your funeral or tap into their inheritance. I have another very small whole life policy just for that purpose, it’s only $50/yr, which I again took out at a very young age. There is an added benefit of life insurance as well and that is no tax for the beneficiary.

Reply

retirebyforty February 27, 2013 at 2:11 pm

I thought most advisers like annuities. I’ll do a bit more research.
Good point about life insurance. I told my wife to go cheap so hopefully it won’t cost too much.

Reply

Another Reader February 27, 2013 at 7:32 am

Between the fees and the risk, I would not touch one of these. Insurance companies are investors, and from what I have seen, a lot of then are not too good at it. A lot of quality insurance companies came very close to going under in 2008 because of the investment risks they did not see. They can only pay you if the net revenue allows them. Look at all of the insurance companies that have pulled out of the long term care market, leaving folks that have paid premiums for years out in the cold.

By the time you “retire” for good, your rentals should be paid off and your other assets should provide you additional income. Dividends alone should offer a 2.5 to 3 percent withdrawal rate without touching principal, based on historical yields. Rental income with the tax benefits should make up the rest.

I am a lot older than you, and it works for me. I do have pensions, but the Social security will just be for additional invesrments when I take it at 62.

Reply

retirebyforty February 27, 2013 at 2:14 pm

I’ll have to see again when I’m older. The rentals are a lot of work and headaches. Well, not a lot, but perhaps I wouldn’t want to deal with tenants when I’m older. Dividend stocks are great, but they can be pretty risky too.
Good point about the long term care insurance. It’s probably better to maintain full control of your money.

Reply

Another Reader February 28, 2013 at 4:22 am

Don’t mix up share price with dividend income. Even at the market’s worst point in 2008, most companies other than banks continued to pay dividends.

You can turn your rentals over to property management when you no longer want to deal with the headaches.

In my experience, you must understand and manage your own money to be successful.

Reply

Kurt @ Money Counselor February 27, 2013 at 10:03 am

Joe, what do you suppose would have happened to the annuity industry had the government not gone into bail-out mode in 2008-09? My answer (which may be wrong) scares me off from depending much on annuities for retirement income.

Reply

jim March 1, 2013 at 3:00 pm

Kurt, what do you mean? I don’t recall the government bailing out a lot of insurance companies. AIG is a notable one. But there were tons of banks bailed out and investment houses crashing too. If we had a depression then how would stocks and bonds held up?

Reply

Nick February 27, 2013 at 12:40 pm

I’m not a huge fan of annuities. I would rather put my money where it can work a little harder for me.

Reply

20's Finances February 27, 2013 at 1:04 pm

Maybe I’m too trusting, but I don’t see anything wrong with using an annuity for part of my retirement plan. I’m not saying I will do it for sure, but I’m not as opposed to it as most of the earlier commenters. Depending on my nest egg, I could see myself putting 10-30% in an annuity so that I have a decent income stream without having to worry. Of course, I’d only sign up with a reputable company that has been around decades. I’m the type of investor who is willing to sacrifice a little bit of return, for simplicity and peace of mind. Granted, that may change in a few decades.

Reply

retirebyforty February 27, 2013 at 2:17 pm

I think 10-30% isn’t bad either. That way you’ll have guaranteed income even if you really screw up your stock portfolio.

Reply

Tom Wachowski February 28, 2013 at 6:09 pm

Having a PORTION of income in retirement come from an annuitized source (pension or annuity) should be part of a retirement income plan. Why? 1) It’s income for life, it will always be there (and if the insurance company goes belly up, someone will likely swoop in and buy up the assets and liabilities, not too worried here). 2) An annuity can protect against longevity (living too long / outliving your money). 3) Consider an annuity a pension (a pension is actually an annuity). Who doesn’t want a pension? In a study I recently came across (sorry, I tried to find the link and couldn’t) retired people were surveyed… those with guaranteed income (annuity, pension, SS) were happier than those without. Apparently, not knowing where your income will come from is stressful (and probably leads to an earlier death, though I don’t have data on that). 4) Even economists from all angles agree that guaranteed income is important to a more secure retirement. Here’s a PhD talking about annuities at 39 minutes into the video (not an affiliate link, just to be clear): http://www.wazillomedia.com/episode/the-ray-lucia-show/the-ray-lucia-show-annuitized-income/500.

Also, remember… an annuity is a contract, not an investment. In other words, it’s sort of an “IOU” from the insurance company to the owner of the annuity (contract). Also, YES… most “advisors” love annuities because they pay high commissions (and the purchaser “pays” for this in surrender charges… that part of the annuity game is a rip off).

In the end, many studies show that having a portion of retirement income come from an annuitized source (annuity, pension, SS) extends the income or raises it. (here’s one Wharton study: https://www.creativemarketing.net/docs/realworldreturns-reviseddec2010.pdf)

Reply

jim March 1, 2013 at 2:58 pm

Personally I think annuities can be a great tool for retirement planning. I would consider getting a fixed annuity to give a minimum guaranteed income level above social security during my retirement. I think the safety of a guaranteed stream of income for life is a good deal. I wouldn’t put all my assets into annuities but I like the idea of a certain minimum guaranteed monthly income that doesn’t depend on how well the market does or how long I might live.

Reply

Dave March 1, 2013 at 3:42 pm

I know in California annuities have an insurance, if the company dies, up to 100,000. This is just like bank accounts protection. I think most states have this type of insurance for annuities in their state, but please check to make sure. They don’t really advertize this fax. But it would help give you piece on mind on this type of investment.

I don’t have any annuities, I have put most of my retirement money into real estate.
It looks like I will retire at 45. All of my houses will be paid off and I will have a nice amount of cash to make sure retirement will be good.

Dave

Reply

retirebyforty March 1, 2013 at 10:44 pm

From what I read, most states have this type of insurance. I should have added that note in the article.
I like real estate too. Rentals is an inflation hedge and they are a great long term investment.

Reply

papadad March 3, 2013 at 9:59 pm

like others, i just dont trust insurance companies to remain “going concern” and see this as a heavily sold product by insurance companies, meaning, it is extremely profitable t them meaning it may not be so lucrative to the individual.

Something eerie to me about handing over my hard earned principle with no getting that back. I think I’d rather “risk it” on most of my money…

I think I can replicate an annuity like return via dividend stocks, tax-free municipal bonds, real estate, and such that I would be hesitant to put more than 15% of a portfolio into insurance-based annuities for the simple fear that the company (companies) could go broke (AIG example)…

Reply

papadad March 3, 2013 at 10:03 pm

forgot to add….

Keep in mind that we are coming off some of the worst historic bond yields in 100 years of history. Likewise, stock market is flat to where it was 2007 (net of dividends) and real estate has been imploded meaning those gains have all but vanished. This is a once in a century sort of economic situation. That all tends to jade one’s opinion on the importance of “guaranteed income”….

One hopefully assumes clearer skies lie ahead….may not be the case…true…but nice to dream a bit…

Reply

retirebyforty March 4, 2013 at 8:24 am

I probably wouldn’t put more than 15% either.

Reply

Mike @ Annuity Rates July 10, 2013 at 3:55 am

I believe annuities can be a great addition to one’s retirement plan but it’s definitely not the ultimate solution where you should put all you money in.

If you are looking for the peace of mind and your portfolio is giving you headaches, maybe the purchase of an annuity will solve this problem as you will then receive a steady flow of income.

On the other side, purchasing an annuity means saying goodbye to your liquid asset. If you need a lump sum payment, some contracts will allow you withdraw as much as 10% of the value but you won’t be able to get more than that.

Joe, did you look at US laws in regards to life insurance company bankruptcy and their remaining contract (for both annuities and insurances). In Canada, if a life insurance company goes bankrupt, Assuris (a Gov owned company) will buy back the contracts and dispatch them among healthy companies so investors don’t lose their money. Therefore, it would be unnecessary to buy several annuities from several companies.

Reply

k8 October 15, 2013 at 8:49 am

There are many forms of annuities/GLWB products. Some authors I’ve found helpful include Wade Pfau, Michael Kitces, and Moshe Milevsky.

I have no association with the authors above – just an interested party with similar circumstances to yours. My spouse and I started a business shortly after graduate school and sold it less than 10 yrs later. That was about 8 yrs ago, and we haven’t had earned income since. We have little SS earnings (most of the business income came through dividends) and a relatively minor percentage of our assets in tax deferred accounts.

I believe annuities may also offer protection against creditors and some other benefits.
Also agree with Mike that losing your liquidity is a big downside. Some advisers suggest you wait until you are older, age 70 or so, and buy an immediate annuity.

Reply

davidmichael January 12, 2014 at 3:57 pm

Wish it were so…but it ain’t!

Many people out there love to talk about annuities, especially the sales people , the insurance people, and the brokerage firms. Why? Because they make money on your money…big time money. And, you stand to lose everything if the company goes bankrupt. I know, some of you will probably say, no! no! it can’t happen. They’re insured, aren’t they? I mean doesn’t each state insure all of these insurance companies and their products? If you say yes…then, welcome to la-la land.

Let me share my wife’s experience, a real life experience. Then tell me what a great investment annuities are for you and the average retiree. After 25 years of marriage to a cardiac surgeon who was worth megabucks, the question arose as to what would be a suitable retirement package for her as part of the divorce settlement. The lawyers pondered and came up with the solution…an $80,000 Annuity with Executive Life (30 years ago) that would be worth $650,000 at age 65 (about 10 years ago). At the time, the interest rate was 10% and everyone agreed it looked good. When my wife reached approximately 64 years of age, Executive Life Insurance Company, the largest life insurance company in the state of California went bankrupt. The Governor tried to work out a miracle to shelter everyone’s investments and savings. Didn’t happen. Eventually, a French Company bought out the policies of Executive Life for cents on the dollar. My wife ended up with $30,000. That’s a real loss of $620,000 she was counting on for retirement.

So when you think of annuities, I suggest caution, and rememebr this story. Hope this helps someone from going through the same experience.

Reply

retirebyforty January 13, 2014 at 9:30 am

Sorry to hear about your experience. It’s just one year too, that’s really bad luck.
I think annuity is a good idea, but probably won’t put too much into it. Maybe 5-10% of our asset for diversification. I’ll have to look at it again when we’re a bit older.

Reply

futurestrader777 July 10, 2014 at 9:01 pm

Sounds like a very bad and rare experience David sorry to hear…but to all the people questioning an Insurance Companies Investment Strategy over a do it yourselfer, like your genius self …think again. Insurance Companies have and will always be the best track record investors in the financial world from an institutional standpoint.The very nature of their business causes them to be such and the actuarial analytics are proof of their understanding . There are lots of advisors that work for Insurance Companies that offer anything you could possibly need under the sun, from brokerage to wrapped accounts, from all forms of life to annuities….they are not any less experienced in managing money than a bias managed money type only advisor…in fact these are the best type to work with why ? because they can offer it all and first gauge the important things like if you were to die would your family be able to live a month without your income ? …well if not that’s a problem that needs to be solved asap. And to all of those bastardizing Annuities, find me “guarantees” with your managed money account at Mr Fisher and his Crony company and ill show you a pig that flies. Annuities for the right situation and needs are some of the most useful vehicles a person could wield in their arsenal for retirement. Everyone can think their a professional at investing and trading in a bull market like 2013 where everyone and their grandmother in equities made money but at the end of the day there will be those that do this for a living and those that don’t. Don’t be a fool just find a professional you personally like, gauged the situation properly and work with them.

Reply

Leave a Comment

{ 3 trackbacks }