Many retirees need stable retirement income. With the substantial reduction in defined benefit pension plans, investors have been left to their own devices to invest for their retirement and to manage their retirement cash flows. Traditional stock and bond portfolios can be volatile and their income stream can be unstable, which has left many with pension envy. A method that has become increasingly popular with retirees is to convert a portion, or their entire nest egg, into an annuity that transforms their retirement portfolio into a stable income stream. The decision of whether purchasing an annuity is best is highly dependent on the individual.
There are several significant benefits and weaknesses to adding an annuity to an investor’s portfolio. While an annuity can provide more certainty for annual cash flows, tax efficiency, and eliminate downside risk, it constrains the investment’s upside, considerably reduces investment flexibility, and leaves an investor with a high risk exposure to one company
The most clear and obvious benefit of an annuity is that it will provide a guaranteed minimum annual payment that will be known in advance and can be planned around. This will help eliminate some of the uncertainty of an investor’s annual cash flows and provide greater piece of mind compared to the uncertain performance of an investment portfolio.
There are many annuity products available with varying options. Some allow the investor or an investment advisor to manage the funds in the annuity, while still guaranteeing a minimum payout. If the funds out-pace certain predetermined hurdles, the guaranteed annual payouts from the annuity could grow even higher. Therefore, the funds in the annuity can be managed aggressively to try to attain a higher annual payout. If the investments perform poorly the investor still has the minimum payments to fall back on. The investor receives the upside of strong investment performance without the downside of a more risky portfolio.
Annuities work well for investors with low risk tolerances. An investor who is unwilling or unable to tolerate volatility in their investment portfolio is normally invested more conservatively with a large allocation to fixed income. Fixed income yields are currently near historic lows and the income received from an investor’s portfolio is very low. Annuity products currently available have payout rates that compare very favorably to both current and historical yields of a conservative investment portfolio. A guaranteed yield through an annuity that is close to or even above the historical yield of a conservative portfolio provides a conservative investor with an income level that is strong on a historical basis without the fear of market losses.
Annuities can also be highly tax efficient investments. When an investor purchases an annuity the growth or income earned by the underlying funds are not taxed. Only the payouts the annuity makes are taxed. Thus, any dividends or income earned between the purchase of the annuity and the withdrawals are growing tax deferred. If an investor purchases an annuity at age 40 and does not take distributions until age 70, it gives an investor 30 years of tax deferred growth. In this sense it is similar to an IRA where investments grow tax deferred, however unlike IRAs there is no limit on the amount of funds that are moved into an annuity.
While the payouts are fixed, which is similar to a fixed income investment, the investment is exclusively backed by an insurance company. If the firm were to declare bankruptcy there is a high potential to lose a portion of the guaranteed payouts. However, if the investor remained invested in a diversified fixed income portfolio they would not face the same concentrated risk and potential significant loss. While there are several large insurance companies offering annuities with a high credit rating, as we have seen with AIG, they have a higher chance to default compared to a more broadly diversified fixed income portfolio.
The yield from some current annuity products offered compares very favorably to current and historical yields, however the average historical total returns for a portfolio mixed 10/90, equity to fixed income has outperformed the baseline yield of annuities. If the annuity holder dies prematurely an even lower performance is realized. Thus, while the annual payouts from an annuity might surpass an average conservative portfolio’s yield, it is less likely that the annuity’s yield will also outpace a portfolios total return.
Annuities that allow potential higher payouts through management of the underlying annuity funds need to overcome high internal fees. As some annuities have step up provisions, if the underlying assets in the annuity outpace the minimum payout level, the annuity holder can receive higher annual payments. However, the fees charged on the annuity reduce the performance and thus the upside potential is hindered. If the investments return 7% and the fees from the annuity are 1.5% then the portfolio would only increase by 5.5%. If a traditional investment portfolio with less fees had that level of performance the investor’s net return would be greater.
In addition, annuities that allow the underlying funds to be managed typically have a limited investment fund universe from which to choose. While, the funds in the annuity can be managed, the fund list that the insurance company provides might not be very extensive and may preclude the investor from selecting investments with high expected results. Most annuities also have higher fees for investors’ who have a more aggressive asset allocation. This curbs the upside potential further for investors who want to attempt to maximize the potential payouts from the annuity.
An investment in an annuity is far less liquid than making investments in traditional asset classes. One can sell out of an annuity investment, but many annuities have surrender fees a seller would incur exiting the investment. Thus, if a need arises to access the funds in the annuity one could incur a substantial penalty in removing the funds. If an investor maintained a traditional investment portfolio of stocks and bonds they would have the ability to access the funds and would not face the same penalties for selling out of the existing investments if their needs require it.
Annuities can also be extremely complicated so it is important that the product is thoroughly reviewed and the structure is understood before purchasing. Raffa Wealth Management does not recommend including or excluding annuities, but recommends that the investor carefully consider the pros and cons of the decision in order to come to a thoughtful conclusion that best fits their risk and return goals.