Tuesday, August 28, 2012
Should I Buy an Annuity? Some Keys Points to Consider
An annuity product is a formal contract promising a certain payment stream. Simply, for a price, you can buy a specified stream of payments, usually from an insurance company. You trade a lump sum (or, in some cases, multiple payments) for a promised payment stream. The stream could be a specified number of years or it could be your “lifetime.” In fact, it is often your “lifetime” and/or the “lifetime of your spouse.” Sometimes, the amount is decreased to your surviving spouse.
The issuer of an annuity – usually an insurance company or pension plan - faces a lot of uncertainty. An actuary is a trained mathematician in these specialized calculations. He or she looks at your age and gender to estimate how long you (and/or your spouse) will live. Once they estimate the duration of payments, they estimate the investment pool necessary to pay them. Today’s retirement lifespan can last 30-35 years, and that’s a lot of uncertainty.
To protect the issuer, an actuary needs reliable estimates for both longevity and investment earnings. If they pay you too much or too long, then the issuer loses money. For a pension plan, this mistake means that the company sponsor will need to add more money to the plan. For an insurance company, that deficit comes out of reserves or profits. Neither of these options are acceptable, so actuaries tend to be (need to be) conservative in making estimates.
What’s this mean to you or me? Partly, it means that we are likely to do better than those estimates. Estimates are necessarily based on the conservative end of a conservative spectrum of investment returns. That’s how actuaries protect the issuer.
There’s a strong chance we can do better. Why? First, we can use a broader pool of investments for our portfolio. Second, we can adjust the portfolio as conditions change (the actuary has to estimate the future today). Third, there’s no margin built into our model for insurance company profit.
In the end, the residual of these factors – any amounts accumulated over the above the actuary’s estimate – may be passed on to our beneficiaries. Remember, most annuity products are exhausted after the annuitant (or annuitants) dies. There is no surplus to the buyer when an actuary overestimates longevity or underestimates investment returns.
That brings up another really important point. An annuity’s stream of payments is inflexible. Should an emergency – or an opportunity – arise, there is no way to interrupt the payment stream. This lack of flexibility is a huge issue for today’s typical retirement horizon.
Another related point is that inflation wreaks havoc on long-term annuity payments. Think back to your salary in 1987. Would you like to live on that amount today? Could you live on that amount today? Now, leap ahead to 2027; how much will today’s monthly annuity payment buy in tomorrow’s world? Avoid any annuity product that doesn’t include an annual Cost of Living Adjustment (COLA). It will reduce the early payments, but add genuine value down the road.
My last point is also important. Don’t buy an annuity product without comparing prices. Every insurance company uses their own actuaries and estimates. These can vary quite a bit at any point in time. Any buyer, especially those with larger sums to invest, should seek quotations from several highly-rated insurers. Most local insurance agents represent just one company, and I’d always recommend a second opinion before buying.
Dan Danford, CFP® is Principal/CEO of Family Investment Center in St. Joseph, MO. The firm offers commission-free investment services for families, businesses, and nonprofit groups.