“Do I Need An Annuity?”

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A reader writes:

How do you see the utility of annuities for folks of age 55+ who are financially independent? Especially if you’re genetically and physically healthy, that seems a winner if we’re talking about spending a few hundred thousand dollars to generate a baseline firewall of income.

Especially I guess for folks less comfortable with ” the scary casino stock market” and thus tempted by the lure of the insurance salesmen?

I’m interested on your take. I find we are increasingly visited by annuity sales people here, pushing products to get Google hits with spam, while there is wheat within the chaff perhaps.

I’m a fan of single-premium immediate annuities when they’re used for their only purpose: longevity insurance. I’m not a fan of indexed annuities, and I’d recommend only one type of deferred annuity (because most of us have already paid for it).

Annuities should only be purchased as insurance, not as an investment. Even the best SPIAs have several major drawbacks:

Picture of money being locked up in an annuity | The-Military-Guide.com

Buying an annuity.

  • You give up a large sum of money in exchange for lifetime income.
  • Your income is only guaranteed by the insurer’s finances (and your state insurance authority).
  • If you die before your life expectancy, you lose the price of the annuity.
  • The money you spend on an annuity can’t grow in other assets or go to your heirs.
  • Annuities have much higher expenses and fees than other asset classes (because annuities are insurance, not assets!).

Financial researcher Moshe Milevsky spent most of the 1990s disparaging annuities for their high fees and deceptive marketing. However, in 2008 when he wrote “Are You A Stock Or A Bond?”, he felt that SPIAs had regained their value through lower fees and better marketing. Everyone contemplating an annuity should read a library copy of this book— at the very least the chapters on annuities.

One of America’s best annuities is also one of its most complex and controversial, and it’s sold by the federal government. Perhaps Social Security is the only annuity that most Americans will ever need. Technically it’s a deferred annuity because its premium is deducted from your paychecks and you can generally only start receiving it at a “full retirement age” (or earlier with substantial penalties).

It’s a safety net that most Americans have already paid for, so you should read the short manual at that link and attempt to maximize the Social Security value in your investment portfolio. Millions of Americans are able to live on only their Social Security income, so you know that it can keep you in food and shelter.

I appreciate that Social Security has significant political risk and funding problems, but if you’re old enough to pay money into the Social Security fund then you can expect to receive some longevity insurance from it. If you feel that you must have more insured income than Social Security then you could purchase a SPIA as well.

However, when you pile more annuities on top of Social Security then you may be over-insured and paying excessive expenses while your money could be put to better use in other asset classes. The challenge is managing your investor’s behavioral psychology emotions. You could try to feel comfortable with the longevity insurance provided by Social Security, and then invest your savings in other assets that offer a higher return (and much lower expenses) than a SPIA. You pay a high price to over-insure yourself.

The only annuity that military retirees will ever need is their military pension (perhaps with survivor benefits). That link will show you how to estimate its value, and you’d have to pay an insurance company even more money for the same benefit. A federal civil-service pension is also a great annuity, as is an annuity purchased from the federal/military Thrift Savings Plan.

The best annuities are backed by a government with the authority to tax its residents and print more money. These annuities (plus Social Security) are all the longevity insurance that’s necessary. Buying more guaranteed income is a waste of your money that could be invested in other assets. It’s far better to try to educate yourself to the point where you can sleep comfortably at night with a little market risk (even if it’s just an index bond fund) instead of over-insuring yourself.

People who have no annuity income (not even Social Security) should buy enough SPIAs (as longevity insurance!) to cover a bare-bones budget. (This annuity income will raise a retirement calculator’s success rate from 90% to 100%.) It probably involves buying contracts at different times and from different insurers so that the state insurance commissioner has you covered in case of (extremely rare) insolvency.

Another investment researcher recommends starting retirement without any annuity income, and then if your portfolio drops below a certain value you would convert most of the remainder to annuitized income. (See Figure 9 on page 10 of this analysis of modern portfolio decumulation.). Jim Otar’s book “Unveiling The Retirement Myth” also recommends different asset allocations to annuities depending on the portfolio withdrawal rate.

Other assets with annuity-like income could be a TIPS fund or a ladder of I bonds. Once again their income is generated by a government with the ability to raise taxes (or print more money) to make the payments, so they’re at least as likely as insurance companies to maintain their payments. These assets are not strictly annuities but they cost less and they might provide sufficient longevity insurance– provided that the federal government keeps selling more TIPS and I bonds as the older ones mature.

Some landlords feel that their rental income is the equivalent of an annuity. However, an SPIA will deposit money in your checking account whether or not you’re taking care of your assets. An SPIA also pays out even if your cognition is declining.

Real estate is a popular investment in Hawaii, but I’ve seen way too many elderly landlords who (for various reasons) have stopped taking care of their properties or whose property managers aren’t doing their job.

Finally, conservative investors who can tolerate some stock-market volatility should investigate conservative equity dividend mutual funds or ETFs with low expenses. A dividend fund diversifies your asset allocation while generating dividend income (and not selling the underlying dividend shares).

In general, when a recession hammers the stock market, most companies continue to pay out their dividends. (They’ve staked their reputation on paying dividends, and their ability to borrow money may depend on maintaining their stock price and their dividend payouts.) Companies that have been paying dividends for years (even decades) will also raise their dividends to stay ahead of inflation.

During the Great Recession many investors (me included) saw the paper value of dividend equity funds drop by over 30%– yet the cash dividend payouts of those funds only dropped a by 5%-10%. If you’re unsure how to add a conservative dividend fund to your asset allocation then learn more at the Bogleheads wiki and consult a financial advisor.

Most annuity buyers can get a competitive quote through Vanguard or ImmediateAnnuities.com (or at least use those sites as a negotiating tool with an insurance company).

Unfortunately Berkshire Hathaway’s annuity calculator was quietly shut down over a year ago. For those with a Thrift Savings Plan account, annuity quotes can be run on the TSP website. Note that even the TSP tries to steer you toward regular monthly account withdrawals (with your money invested in the TSP’s low-expense passively-managed index funds) instead of an annuity.

Related articles:
TSP withdrawal options
TSP annuity options
Tailor your investments to your military pay and your pension
Asset allocation considerations for a military pension (part 2 of 3)
“Present value” estimate of a military pension
How much will military veterans leave on the table?
Military retirement with low savings
Do you really need $2M to retire?!?
Retirement planning: “Just tell me what to do!”
Fixing The Fixed Indexed Annuity

WHAT I DO: I help you reach financial independence. For free. I retired in 2002 after 20 years in the Navy's submarine force. I wrote "The Military Guide to Financial Independence and Retirement" to share the stories of over 50 other financially independent servicemembers, veterans, and families. All of my writing revenue is donated to military-friendly charities.

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