Annuities have received some bad press in the financial planning community. They tend to be denigrated because of their cost – “They have way too many fees, many of them hidden” – or because they are not hedged against inflation, effectively reducing their usefulness at exactly the time (later in life) when they’re designed to provide the most value.
What’s important to recognize is that not all annuities are the same, and that allocating a portion of your retirement portfolio to two types in particular can provide better longevity protection than investing solely in stocks and bonds.
As a quick refresher, an annuity is a contract between you and an insurance company. You pay them a certain amount of money either up front or over time, and they guarantee to provide you periodic income starting at some point in the future for as long as you remain alive.
You can think of annuities as having two phases: the growth phase and the payout phase.
During the growth phase, the money you’ve invested in the annuity grows either based on prevailing interest rates (with fixed annuities) or via a more complex formula involving stock market growth (with variable annuities). When you are ready to begin collecting income from the annuity, you annuitize it. From that point on, you receive a fixed monthly or annual lifetime payment from the insurance company that does not change.
Pros and cons
It is useful to understand two important disadvantages of most annuities: (1) There are typically fees, caps and surrender charges imposed during the growth phase that can significantly impact growth, and (2) you cannot know how much income you will actually receive from the annuity until you annuitize it.
The two annuities that are exceptions to these limitations are single-premium immediate annuities (SPIAs) and deferred-income annuities (DIAs). What’s different about them is that there is no growth phase – you pay your premium up front and immediately annuitize. The income stream begins right away for SPIAs, and at a defined time in the future for DIAs. The longer the deferral period, the greater the DIA payout. In either case, the payout amounts are specified up front in the contract.
Wade D. Pfau, professor of retirement income at the American College in Bryn Mawr, Pa., found that by allocating a portion of their retirement portfolios to SPIAs and DIAs, retirees can achieve more liquidity and better longevity protection at a lower cost than investing only in stocks and bonds. He determined that putting approximately 40 percent of your assets into a DIA with a 10-year deferral period provides the most downside protection for spending shortfalls, based on today’s interest rates. A shorter deferral period leaves more time for inflation to erode the value of the annuity, and a longer deferral period risks having your financial assets depleted before receiving your DIA income.
Of course, money put into an annuity goes to the insurance company after you die, not to your heirs, unlike money invested in the capital markets or in real estate. So if your estate plan calls for leaving a legacy to your children or others, you will likely want to limit the amount you put into an annuity. Pfau calculates that you can put just 10 percent of your assets into a DIA if you extend the deferral period to 25 years, while still getting better longevity protection than not using one at all.
Despite the many drawbacks with annuities, there are two, SPIAs and DIAs, that can be very useful in diversifying the income streams from a retirement portfolio and in helping improve the likelihood that you don’t run out of money in retirement.