Insurance agents and financial advisors who sell annuities often think annuities are the best solution for retirees and recommend cashing in the investment portfolio in favor of annuities. Financial advisors who charge based on a percentage of your portfolio (%AUM) think annuities are expensive and unnecessary and would not likely recommend you cash in some of your investment portfolio to purchase an annuity. This bias in advice based on compensation methodology is one of the reasons I am such an advocate of a flat-fee pricing model (read our Insight entitled "Why a Flat-Fee Advisor is Best for Retirees" for more). Much has been written about annuities in the press as well. Everything from the benefits annuities can provide to retirees to their blatant misuse by some unethical insurance agents and financial advisors trying to earn large commissions. Annuities are neither inherently good nor bad. Annuities are just a retirement tool. Like any tool, they can be good or bad depending on their selection and usage.
What is an Annuity?
An annuity is a financial contract with an insurance company that promises to pay out a benefit contingent upon an event in exchange for a premium (i.e., fee) paid. Annuity contracts are not standardized and are highly customizable along the following lines:
- Annuities can be bought with a lump sum or a series of payments
- Annuities can pay regular income immediately or at some point in the future
- Annuities can come with benefits that are fixed, variable, or indexed
- Annuities can add a number of “riders,” or customizations, that can be made to guarantee certain additional benefits in exchange for additional premium (or fee)
While the flexibility of an annuity contract is part of what can make them a good tool in retirement, the flexibility is also what can lead to consumer confusion and abuse.
An Annuity is an Insurance Product, Not an Investment
It is important to remember that an annuity is an insurance company product. The primary role of an insurance company is to manage risk by assuming the risk for a premium. Insurance companies are quite effective at managing risks because they can pool risks over many individuals, allowing them to project more accurate and consistent results. This ability allows insurance companies to insure against risks at a cheaper rate than an individual who chooses to self-insure.
An annuity is in essence an insurance policy against running out of money during retirement. Insurance is costly, but there are times it may be necessary if you are unable to “self-insure.” To “self-insure” in this case is to have investment assets or savings that can be drawn upon during retirement to fund retirement expenses and a risk profile that is tolerant to the drawing down on those assets.
Insurance is not an investment or savings vehicle, though many who sell annuities will try to present them as such by promoting the variable or indexed benefit features. Insurance doesn’t make for good investment or savings vehicles because their primary objective is to manage risk. You have to pay for that risk management feature, which effectively reduces the return. Many retirement planning objectives can be accomplished without the use of annuities and insurance, but like any tool, they should be considered and used when appropriate.
What are the Pros and Cons of an Annuity?
Annuities present several issues. Annuities are non-standardized, complex financial contracts that are rarely well understood by consumers. Not only are consumers generally not in a position to understand these contracts or the tradeoffs they are being asked to make, aggressive salespeople often poorly present all the facts necessary to make a sound decision. Insurance agents and financial advisors that sell annuity contracts can earn large commissions, especially as they add riders and push the variable or indexed benefit varieties. All of these issues are compounded by the fact that annuity contracts can be expensive to the consumer, and the decision to purchase an annuity is often irrevocable.
Annuities do, however, have the unique ability to insure that a retiree has a specified amount of income through the entirety of retirement. This insurance can help a risk-averse retiree or a retiree lacking sufficient financial resources to feel more comfortable about spending money in retirement. A research paper entitled “Guaranteed Income: A License to Spend” written by David Blanchett and Michael Finke shows retirees feel more comfortable spending money from a recurring stream of income than they do from savings. After 30 or 40 years of working and earning a steady paycheck from which expenses were met and excesses saved, it is more natural for people to feel comfortable spending from a recurring stream of income. Drawing down on investment assets and savings to meet expenses feels very unnatural and is difficult for many. The research shows that people who meet retirement expenses from drawing down investments and savings tend to combat the unnatural feeling by being overly conservative and spending even less than they would have had they exchanged their investments and savings for annuities.
What’s the Right Solution?
While the conclusions reached in “Guaranteed Income: A License to Spend” are enlightening, I think there is more to solving the problem of helping retirees feel comfortable responsibly drawing down their assets to maximize their quality of life in retirement. Annuities can be a piece of the puzzle, but so too is a solid retirement plan that is well understood by the client and reviewed often so small changes can be made along the way as needed to remain optimal. A solid retirement plan considers all assets (not just the investment portfolio), applies dynamic portfolio withdrawal rules, invests portfolio assets in a maximally diversified, low-cost, tax-efficient way, and integrates tax planning and optimized withdrawal order sequencing (read our Insight entitled "Steps That Should Occur in a Proper Retirement Planning Process" for more). If this sounds complex, it is because it is. Retirement is complex, but there are some excellent tools and systems that can help us manage and remove the complexity so that a retiree can trust their retirement plan and the spending down of their assets, allowing them the confidence and peace of mind to maximize their one-and-only retirement!
If you need help finding the right solution for you, we stand by ready to help. Contact us here at any time.
ABOUT THRIVE RETIREMENT SPECIALISTS
Thrive Retirement Specialists is a retirement planning specialist dedicated to delivering a more thoughtful and strategic approach to retirement planning for those nearing or in retirement. We are a fee-only Registered Investment Advisor (RIA) offering a single, flat-fee service entitled ThriveRetireTM that goes far beyond what has traditionally been known as retirement planning. ThriveRetire™ is an engaging ongoing 8-step retirement planning process and investment management service that seeks to identify all risks, assets, tools, and tactics to develop an optimal retirement plan designed to support your ideal retirement lifestyle and goals to the fullest extent possible. With every interaction, we seek to inform and serve, so our clients can safely trust their ThriveRetire™ plan and process, leaving each client with the confidence and peace of mind to live a vibrant and full life through retirement.
ABOUT ANTHONY WATSON, CFA, CFP®
Prior to founding Thrive Retirement Specialists, Tony spent eight years serving as the Chief Investment Officer of a firm where he provided advice and investment management services to over 600 individuals representing at the time over $1.5 billion of investments. Before this, Tony served as Vice President at J.P. Morgan Private Bank, where he advised high- and ultra-high net worth individuals on all matters of wealth, including investments, portfolio construction, portfolio management, and retirement planning.
Tony lives in Dearborn, Michigan, with his wife Dawn and daughters Emma and Anna.
- BBA in Finance, Walsh College
- MBA, University of Michigan, Ross School of Business
- Chartered Financial Analyst (CFA)
- Certified Financial Planner (CFP®)