Our friend asks us, should I consider an annuity for my retirement?
Annuities are products that most people have heard of, but few people know it well. This lack of knowledge may have led to an adoption rate that is lower than expected, especially considering its attractive risk management characteristics.
An annuity, at its most fundamental[1], is the exchange of lifetime periodic payments for a lump sum. While an exchange of this nature is familiar when talking about debt, the absence of a known maturity date complicates things, and the lack of an explicit rate of return becomes a major hurdle for analysis and comparison.
Nevertheless, the value of an annuity lies in its ability to mitigate longevity risk, since cash inflows would not cease until the death of the annuitant[2].
Keep in mind that in a traditional investment, it may be necessary to distribute gains and principal to meet retirement expenses, and, in cases of longer-than-expected longevity, capital and gains may not be enough[3]. For annuities, this risk does not exist since it is transferred to the issuer of the annuity.
However, a “breaking point” rate of return could be calculated by estimating the discount rate that would equate the capital outlay and the future cash flows received. A survival that is shorter than life expectancy would imply a lower return and vice versa[4]. This makes the usefulness of annuities to hedge longevity risk evident. In addition, annuities also provide peace of mind because the cash flows are immune to interest rate movements or the state of the markets[5].
How does the insurance company manage these payments for a potentially long and indefinite period? The insurance company, having a large group of customers, can use the surplus capital of those who will not reach their life expectancy to cover the payments to those who will exceed it. This is called mortality credits, and they are calculated actuarially.
In conclusion, the proper way to evaluate a competitively priced annuity is by focusing on the benefits of the certainties it offers. Not surprisingly, their most common use is to supplement public pensions, thus trying to assure coverage of basic or core expenses with sources of guaranteed income. The rest of the assets can continue to be invested in the traditional way, facing short-term volatility in the expectation of long-term real returns. Recent studies[6] show that annuities help people spend more freely in retirement.
We can’t conclude this introduction to the topic without mentioning another popular product under the general annuities category: Deferred Annuities. These annuities place emphasis on the capital accumulation phase, including different investment options and a life policy, and allowing for taxes on the gains to be deferred. The contributions are invested in fixed rate products, index-linked rate products, or directly in investment funds. For deferred annuities, the decision to annuitize the capital is usually made years later and may not even be made[7].
Annuities are a very interesting and unique product that should be considered when planning for retirement. Its value is maximal for those looking to secure coverage of basic needs or core expenses and for as long as necessary.
Notice: The information provided herein is for educational purposes only. Portfolio Resources Group does not guarantee the accuracy of any tax recommendation, as we do not provide tax or legal advice. Consult a tax professional to ensure that the recommendations are appropriate for your particular situation.
[1] The market equivalent would be the Single Premium Immediate Annuity (SPIA).
[2] There are versions on two lives, over a fixed period, and with reimbursement of unused capital.
[3] It is for this reason that retirees without annuities tend to be more frugal during retirement.
[4] Being this the mirror image of a life insurance product.
[5] Being a long-term product, the main risks are the loss of purchasing power and the solvency of the company issuing the annuity. Fortunately, both risks can be mitigated via optional cost of living adjustments and proper due diligence.
[6] “We explore how the composition of retirement wealth is related to retirement spending and find that retirees who hold a higher percentage in annuitized income spend more than retirees with an equal amount of non-annuitized wealth.” Guaranteed Income: a license to spend. Blanchett, D. and Finke, M. Research Paper, Retirement Income Institute, June 2024.
[7] Insurance companies have been offering lifetime income guarantees, a sort of withdrawal insurance in exchange for a premium and sometimes subject to restrictions.