I do not love annuities. I don’t even like them. I’ve never recommended them to clients, and I highly doubt that would ever change. It’s still not even going to change today. That said, there is one strategy where I think it makes sense for some people.
Before we get into the strategy, let’s briefly discuss the two annuities I really don’t like, and then we’ll talk about the one I dislike the least.
First is the Variable Annuity. A variable annuity is a type of annuity contract has two phases, the accumulation phase and then the income phase. So an investor can put the money in a contract, delay payments of income, during which the money invested in the annuity can grow on a tax-deferred basis. Then after some period of time, they can turn on the income from the contract.
I don’t love these contracts because the guarantees aren’t all that impressive, the fees are pretty high, and since you’re locking up this money in a contact, there is a period ranging from 5-10 years where you can’t get this money back in case you need it. So I don’t ever recommend variable annuities.
Next is the Fixed Index Annuity. A fixed index annuity is a type of annuity that guarantees you will keep your principal, and the potential for higher gains linked to the performance of a specific equity index, like the S&P 500. I don’t love these policies because the commissions are quite high, and there are different restrictions on how much you can earn in a given year. They also have a surrender period where you can’t reclaim your money unless you are willing to pay a surrender charge.
So neither of these products are particularly attractive in my mind, and if I were you, I would just avoid them entirely.
So what’s the annuity strategy that I do like? Here’s how it works:
Find your monthly expenses in retirement, let’s call it $5K/mo. You then subtract your and your spouses social security income, which we’ll say is $3K/mo combined. So now you need $2K more per month to satisfy your monthly needs. While the traditional approach, which I recommend and endorse and use with my clients, says to take this money from your stock and bond portfolio, this annuity strategy is different.
Because with this strategy, you take a lump sum of money and purchase an immediate annuity that will generate you $2K/mo. Depending on your age/gender, that might cost you $325K for a lifetime annuity (you can read more about these annuities, often called single premium immediate annuities, here).
With your $3K of social security income plus $2K of income from the annuity, now all of your living expenses are met through “guaranteed” sources of income. I put guarantees in quotes because we do have some significant assumptions, which is that social security will not have a benefit reduction in your life, and that the insurance company continues to operate. I should note that insurance companies do have insurance in the event they ever go bankrupt, and it’s very rare for them to go under.
So why would you do this? The general idea is that as you age, we get a little more conservative with our risk tolerance and the ups and downs of the stock market that we can, and can’t, handle. I’ve had clients say to me, Scott, I could be in 100% stocks in my 30s, 40s and 50s, no problem, but now that I’m in my 60s, I just can’t stomach that, especially when I will be using that money for monthly income.
With this strategy, you are generating enough stable income so that you don’t have to worry about the stock market to meet your monthly needs. That fact then hopefully relieves some of the worry that you have about volatility in the rest of your investments. And instead of you being in a very conservative investment allocation, you can then increase the percentage of stocks in your portfolio, which historically have gotten a better return than bonds and cash.
In other words, since your monthly needs are met via stable sources, you can theoretically be a little more aggressive with your stock and bond portfolio. As you can tell, this strategy is part math and it’s part psychology.
However, are are some significant downsides to this strategy:
-If purchasing this annuity takes up too large of a percentage of your investment portfolio, so you are left with not a lot of cash for your other investments, that takes away a lot of the benefit of this strategy.
-Because when we purchase an immediate annuity, we lose a lot of liquidity. And we don’t want you ever running out of money. So we need to make sure that you’d have enough stock/bonds/emergency fund to last 30 plus years in retirement.
-We also need to remember that when you lock up a large sum of money, it will lessen your financial flexibility, should you ever need a big chunk of change
-Also, most immediate annuities do not offer a COLA, or cost of living adjustment. Which means that every year your annuity is losing purchasing power every year.
-You can add on a COLA, but that means it’s either going to cost you more to purchase your desired income amount, or you can use the same purchase price but it will lower your benefit amount.
-You also have to realize that putting a lump sum of money in an annuity is a very conservative financial move, which means that if your stock and bond portfolio performs well, you will likely underperform those returns. That could be a tradeoff you’re willing to accept but you have to consider that in this equation as well.
-Finally, when you pass away, these annuities will likely end at that time. There are joint and survivor annuities, designed for couples, which would continue until the second person passes. When they die, the annuity dies as well. If you have kids or charities you want to leave money to, these annuities would not be able to satisfy that desire. So you’d have to use other money to account for that.
Alright, and that’s all I have for this strategy. Again, I don’t recommend this strategy as it’s a little more conservative than I like. A boring, well diversified portfolio of low cost stocks and bonds has historically (cannot guarantee the future of course) earned you solid returns while maintaining complete flexibility on your assets, while also allowing you to leave it to your kids. So I will be sticking with that approach, but if you are dead set on increasing your stable income, I would look into this strategy as a way to meet your living needs and hopefully decrease some of the stress that comes with getting your income from the stock market in retirement.