Should I Buy an Annuity? Some Keys Points to Consider

What is an annuity? Annuity payments are different from annuity products. Annuity payments are just an equal stream of payments over a specified period of time. So, if someone agrees to pay you $500 per month for 10 years, that’s an annuity payment.

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.

LTC Benefits? Beware this Hybrid Product (Agents are Selling the Heck Out of It!)

I’ve met with three different people in the past month who were contemplating or, in one case, had already purchased a unique new “product” offered by insurance companies. The product is actually a combination of two products; an annuity and an insurance policy. They pair these two together and then “include” a Long Term Care (LTC) benefit from the combination.

The LTC benefit is what customers think they are buying. It is certainly what agents are selling.

But the LTC is really just an acceleration of the death benefit that they’ll have to pay (upon death) anyway. So, they sell the future value of the annuity plus the death benefit, and then show that you can withdraw from this future amount in monthly LTC benefits. But, of course, those benefits are deducted from the eventual death benefit. They are giving your own money, and claiming it’s an LTC benefit!

If you separate the two, the annuity amount will likely grow better and quicker as an investment account or IRA and a term life policy will be much cheaper than whole life insurance. But insurance illustrations never show the opportunity cost of 1) lower annuity returns, and 2) the inferior investment component of the life insurance policy. The agent doubles up his commissions (whole life policy and annuity) and the insurance company makes ongoing fees from both parts (and possibly adds a fee for the accelerated death benefit). And then it pays a quasi-LTC benefit from your own money! It’s a ridiculous product, but they are selling the heck out of them today.

My recommendation? Beware this sales gimmick. If you genuinely need LTC insurance, buy that product directly from a reputable source. If you need life insurance, buy a term life policy to cover your beneficiaries. Annuities? Find a better place to invest your money.

Suze Orman on annuities

From the July 2011 Costco Connection:

Is an annuity really suitable for me?
Is it possible to make money without taking on risk?
How can I legally give up a wallet-draining time share?

Read Suze Orman's responses here.

Annuities: guaranteed income, but the particulars matter

On Mondays, we post a question from a reader and answer from Dan Danford. Today's question centers on annuities. If you have a question you'd like to see answered, post it in the comments section here or send it to us on Twitter @family_finances.

QUESTION: I am 62, and looking at investing in a fixed annuity. They seem like a good deal, but I’m confused by the different types of annuities offered. What type do you think is the best? I have a 401 (k) with about $500,000 in it, and I will be receiving some social security and a small pension. I’d like to preserve some of my funds for my children.


ANSWER FROM DAN DANFORD: Annuities are investment contracts sold by insurance companies. They come in many shapes and sizes, but we'll focus on the fixed annuity today. In its usual form, a fixed annuity trades your stack of money for a stream of monthly payments. That stream could start today or some date in the future. It's called a "fixed rate" annuity because the interest rates (and payments) are set by the contract, and don't change in the future.

So the interest that you earn, and the payment schedule and amount, are all part of that initial contract. In a way, the buyer is trading an uncertain future for a certain stream of payments. For most of us. that's an appealing idea because we hate uncertainty! That's why these types of contracts are popular with the public.

But, like many things, popularity isn't always a good measure of character. A downside of buying "certainty" is that you give up flexibility. Once you've locked in those rate and terms, you're stuck with them for the rest of your life. What if you need emergency cash? What if interest rates rise dramatically, or inflation rages at 8 to 10 percent a year? What if you die suddenly after only collecting eight payments? Though unlikely, these things have happened in the past, and they left fixed annuity holders in a (genuine) fix.

Based on the statistics, you have many years of "life expectancy" left. Don't be quick to jump into an annuity (even if the seller seems sincere and charming). If you eventually decide an annuity makes sense for you, keep a sizable nest egg out to meet future emergencies. With the contract you do buy, seeks a couple of important provisions: annual inflation adjustments for your monthly payments, and five- or ten-year certain (a guarantee that your beneficiaries collect payments after you are gone).

It also makes sense to check the insurance company's rating because your ultimate guarantee is their success in business. They can't honor contracts unless they are still operating. Last, and this is a big issue, get quotes from several different companies. Each company sets their own terms and makes their own predictions about future investment returns and lifespan. You'll be surprised at how much difference that makes in your guaranteed monthly payment.

Annuities: watch out

Humberto Cruz is a bright, astute financial expert who answers questions from the public. Today, he answered a question about annuities in the Kansas City Star. You can see the question and his answer here.

Here's my thoughts on it.

These types of products become more popular during market turmoil. It's human nature prevailing over investment history. To me, the worst time to enter into contracts like this is as a response to the investment environment. In essence, you are entering into a long-term contract (fifteen years at least) because of shorter-term market conditions. And, in this case, you are doing it when interest rates (used by the insurance company to determine your payout) are near historical lows. Good for the insurance company and bad for you. Need I add that it's an easier sale for insurance agents, too?

In some circumstances, using an immediate annuity could be a wise choice. But the wisdom of that choice is best determined when the markets are more "normal." My advice would be to carefully consider the options over several months. Try a ladder as suggested by Mr. Cruz to catch some better payouts when rates rise again. Don't let fear drive your retirement decisions.