Are Annuities a Good Idea for Retirees?

Hello, everyone, and welcome back to another episode of Retired-ish. I'm your host, Cameron Valadez, Certified Financial Planner. And today, we are going to discuss a topic that is a hot button for many retirees, and that is annuities. What is an annuity? How do they work? And are annuities a good idea for retirement?

The topic of annuities is definitely an interesting one since many people are in either one or two different camps. They either don't know much about them at all, or they completely fear and avoid them due to some horror story that they read on the Internet about someone else's experience with an annuity. Now even financial professionals have wildly different opinions on annuities and whether or not they are worth the benefits that they can provide. Some professionals love them; some hate them. However, I'm not here to settle that score but instead to let you decide since, ultimately, people value things differently. Ever been invited via postcard to a nice fancy dinner at your local steak house, free of charge, by the way, to listen to a retirement seminar? Yeah. I bet you have. And I wanna let you know that that is not the type of discussion we will be having today. And the specific annuities that they may pitch at those seminars are not necessarily the kind I will be referencing in this episode. If you've ever attended a fancy steak dinner presentation like that, just a heads up. When it comes to those dinners, the quality of the information or product they are pitching to you is typically inversely related to the quality of the food they are providing you. So tread carefully. My goal with this episode is to hopefully educate you enough about annuities so that you can determine whether or not you should even consider them in your planning efforts.

0:02:09 Notice how I said consider and not that you need one as part of your plan. I also want a caveat that I am by no means a huge proponent of annuities. But I am also not naive when it comes to them, and you shouldn't be either. No matter what anyone has told you or what you've read, an appropriately placed income annuity in a well-constructed comprehensive retirement plan can add significant value and risk reduction to a retiree. Especially those who retire without any lifetime pensions. In my opinion, there are good annuities and bad. And there are also many pros and cons to any annuity, most of which we will discuss. That being said, there are also many types and flavors of annuities. Some of which I will mention. However, I will focus this discussion on one of the only general types of annuities I believe is even worth considering, which is the deferred income annuity. Before we dive in, I wanna state the primary reason why I believe a retiree would even consider certain annuities as part of their retirement plan in the first place.

Certain annuities should be considered if you want to reduce what is called longevity risk in your retirement income strategy. This is done by transferring certain risks to an insurance company rather than accepting that risk yourself with your other investments, such as bonds. I discussed longevity risk in our previous episode, which I will link to in the show notes, which was one of several risks that threaten your income throughout retirement. Notice how I said bonds and not stocks. In my opinion, if you end up considering an annuity, it should be to replace some of the bonds in your overall portfolio. Not necessarily to go purchase an annuity with money that you may have had in stocks previously because you were spooked by a drop in stock prices. I will say it again. I do not believe that you should consider an annuity as a replacement for your stock market investments. More on this later. Okay.

0:04:09 So, circling back, longevity risk is essentially the risk of you outliving your money, which arguably is a retiree's worst fear, even more than death itself. Most people underestimate how long they're going to live. This also means that they misjudge how long their money will need to last. Chances are, a long retirement is in your future. And as you've heard me say on this show before, you want the plan for longevity when creating your retirement plan since it is a worst-case scenario for your nest egg and your finances. Over the last forty years, the average life expectancy has increased by more than ten years, according to OECD.org. In fact, according to the Society of Actuaries, statistics show that for a sixty-five-year-old couple, there's almost a twenty percent chance of one of them living to age ninety-five.

Today's retirees face some retirement planning challenges that simply didn't exist twenty to thirty years ago. This is unlike previous generations who had the luxury of having their entire retirement funded by nice fluffy pensions with cost-of-living adjustments from their former employers or even the government. Your parents were likely the beneficiaries of such pensions. You, however, are likely to enter retirement without a pension. In which case, the assets that you've been responsible for accumulating on your own in your 401(k) or IRA, for example, could be your most vital source of retirement income. Those generous pensions are becoming a thing of the past. And even if you are to receive some sort of public or private pension, the benefits are far less generous than they were twenty years ago. And the income that they provide may still not be enough to fund your desired retirement lifestyle. So now that you have a basic understanding of longevity risk and that you have the option of reducing that risk by transferring it to someone else let's look at how you might do so via an annuity.

0:06:01 First things first. In general, what is an annuity? And what are some of the pros and cons of annuities? An annuity is simply a method or tool in order to help produce retirement income and fund retirement spending. I want to caveat that, nowadays, there are many annuities out there that are sold for reasons other than retirement income specifically. But for this discussion, we will focus on annuities meant to provide income.

Annuity contracts are sold by large insurance companies and can be invested in with cash in your bank account, for example, or purchased in a retirement vehicle such as an IRA or 401(k). They can be purchased before or after you actually retire it doesn't matter. They typically provide a stated amount of income for life or a specified period, such as over ten years. They can even provide income over your life and a spouse's life. Annuities can be funded with a lump sum purchase payment, a series of purchase payments, or a combination of both. Typically, the buyer of the annuity is also the owner and makes decisions on the annuities, such as deciding who the beneficiary is and what benefits they want their annuity to provide. Then there is also what is called the annuitant. The annuitant is the person whose age and mortality the future income payments will be based on. This is typically also the owner, but not always. Then you have the beneficiary. This is the person who would receive any potential death benefits the annuity might provide or any potential contract value left over should the contract holder die prematurely. The main attraction, so to speak, that most income annuities can provide is the fact that the income payments are guaranteed by the claims-paying ability of the different insurance companies. These guaranteed payments can continue for life, even if you have been collecting from the annuity and have actually exhausted the real value of the annuity itself or what you funded it with.

0:07:55 Using a simplified example, if you had, let's say, three hundred thousand dollars in the bank or in cash in an IRA, and you decided to withdraw one thousand six hundred and twenty-five dollars a month to supplement your other retirement income without any sort of return on that account or on that cash, that three hundred thousand dollar balance would run out in a little over fifteen years. If we had the same parameters, but that three hundred thousand was used to instead purchase an income annuity that would pay out the same exact one thousand six hundred and twenty-five a month, you would continue receiving that payment each month for life even after the initial three hundred thousand is exhausted around year fifteen and goes to zero. When you buy an annuity, you are essentially turning that lump sum into an income stream for life that you can't outlive.

Now you may recall that I mentioned the term deferred income annuity earlier. In general, a deferred income annuity is one where you can fund it using any of the methods I previously mentioned but then let the funds “marinate” over a number of years to provide some sort of rate of return on the invested dollars or increase the withdrawal rate later in life that you can take from that annuity when you want to begin receiving income from it. This is opposed to an income annuity that starts paying you immediately after purchasing it. These are often called immediate annuities. Think of deferred income annuities, kind of like delayed Social Security retirement credits. Each year you delay Social Security past your full retirement age, you currently get an eight percent increase per year in your benefit along with cost of living adjustments up till age seventy. While they don't work exactly like Social Security does, this is the general concept behind deferring your annuity payments until a later date. In fact, you can think of Social Security itself as a form of annuity guaranteed by the US government. You've funded it slowly over your lifetime via deductions from your paychecks, and they have promised to pay you for life a stated amount of retirement income. If you have a career in which you do not pay into Social Security, it is likely because you are actually paying into a public pension system instead, such as something like Calpers or Calsters in the state of California, which is also similar to a basic deferred income annuity.

0:10:26 An important potential benefit to mention regarding annuities is the fact that they are also what we call tax-deferred similar to a retirement account. Tax-deferred simply means that the interest earned in the annuity is not taxed in each year in which the interest is earned, and it is instead deferred until you begin taking the money out. This can allow more money to stay in the account and therefore compound over time. Now, I wanna remind you that tax deferral is inherent to retirement accounts like IRAs and 401(k)s, but it isn't with non-retirement funds. Recall that with investments outside of a retirement account, such as in a trust account or a brokerage account in your name, you pay taxes on interest dividends and potential capital gains in the years incurred. Therefore, this tax deferral benefit of annuities is only relevant when purchased with non-retirement funds. If you purchase an annuity in your retirement account, it is already tax-deferred. So this specific benefit is a moot point in that case. This tax deferral feature can also provide some other ancillary benefits by keeping your taxable income lower as well as your adjusted gross income. These are both metrics used when figuring the eligibility and extent of certain deductions, the taxation of Social Security, and the tax rate you pay on all of your income.

0:11:45 Here's a basic example that's all too common. Let's say that you have an IRA, Roth IRA, and inherited a trust account from your late mother and father. The trust account is fairly sizable since they were fortunate enough to receive private pensions in addition to Social Security to fund their retirement lifestyle. And therefore, they were able to save a nice nest egg on the side for your benefit in a non-retirement account. So you've done some financial planning and decided that you wanna use the non-retirement money to help fund your own retirement lifestyle alongside your own hard-earned savings. And so you invest that money in a mixture of stocks and bonds and maybe even some real estate. Each and every year, the interest, dividends, rental income, and potential capital gains are subject to taxation. All of those metrics stack together along with any other income sources you have that determine your income. Although, some income sources are taxed different than others. If, instead, you chose to have some of the money put into an annuity from that non-retirement account, the taxes on the interest earned in that annuity would be sheltered from taxation until you took the money out. Therefore, your income in each of the years you defer or let the funds marinate would be lower than if you had that money say, invested in bonds, for example. Therefore, your taxable income and AGI that adjusted gross income could also be reduced during those years to allow for more financial planning strategies to be implemented, and deduction had.

Now again, of course, I'm not saying that everyone should do this because, as always, it depends on your exact situation. Sometimes doing something like that can actually blow up your finances later in life when you begin taking the income. You'll have to take the rest of your situation into account and look at things holistically. Now that example leads me to one of the potential cons to investing in an annuity with non-retirement funds. And that is that the interest you earn on your non-retirement annuity is taxed as ordinary income when you take it out later.

0:13:51 If you remember from previous podcast episodes, ordinary income is simply income that is taxed at the regular federal income tax rates. Similar to income from a job. This is opposed to income that can receive lower preferential tax rates, known as qualified dividends or capital gains. Therefore, some people may not want to take money invested elsewhere currently in stocks, let's say, and invest in an annuity. Since it will essentially convert this money into money that will be subject to more taxation. While this is a valid point, this is why I also say that if you were to consider a deferred income annuity to begin with, it should be considered in the context of replacing your bond holdings in your portfolio if possible. The reason for this is that interest earned from taxable bonds such as government and corporate bonds is taxed as ordinary income anyways. This means that either way, annuity or not, the income from those bonds in a non-retirement account is taxed the same. Bonds do not generate potential qualified dividends like many stocks do, which are subject to lower rates.

In addition to the earnings being taxed as ordinary income, when you fund an annuity with nonretirement money and therefore get the benefits of tax deferral, the earnings become subject to rules similar to that of retirement accounts in which the earnings will also be subject to a ten percent premature withdrawal penalty if taken out of the contract before age fifty-nine and a half. This may sound familiar because it is a similar rule with accounts like IRAs and 401(k) plans. The main difference here is that when you have an annuity funded with nonretirement account money, it is only your earnings or interest in the contract that are subject to this rule, not the money you funded the annuity with. This is just something you have to give up in lieu of the IRS allowing you to receive tax deferral on that money. Just know that these tax effects are something to consider in the grand scheme of things. And again, with an annuity purchased in a retirement account such as an IRA or 401(k), The ordinary income taxation and the ten percent premature withdrawal penalty issues are a moot point. Since those rules are already inherent for those retirement accounts.

0:16:06 Another potential con of annuities can be the fact that many, but not all, have what are called surrender charges. Surrender charges are fees typically based on a sliding scale that are imposed on potential withdrawals in the early years of an annuity. They are meant to protect the insurance carrier against those who “leave early.” For instance, you could have a seven-year surrender period in which the first year has a charge of seven percent. Then it declines one percent each year until after year seven. Then the charges go away, and the contract is fully liquid. Now, this is just an example. This is one of those areas where you can begin to see the good, the bad, and the ugly when it comes to annuities. I have seen some with no surrender periods, three years, five years, seven, all the way to fifteen years or more.

Now, I'm not at all saying to judge an annuity completely based on the surrender periods or charges, but it would be a good idea to compare that metric between several annuities you may be considering with substantially similar benefits and costs. I mentioned that this is a potential con to annuities because you should only be considering an income annuity in the first place as a long-term investment vehicle. You also should not be investing most of your liquid net worth into an annuity, thereby limiting your ability to access money in an emergency, which would be one of the reasons why you tap into it early and incur one of those surrender charges. That being said, you should have enough planning already done to reduce the probability of needing to tap into the annuity early. Therefore, these potential charges may not be an issue since you only pay them if you “break the piggy bank” too early. And as a quick side note, it's worth mentioning that many annuities have provisions that actually allow a contract owner to withdraw from their annuity without penalty during the surrender period. This is typically stated as an amount up to ten percent of the contract value in each given year.

0:18:02 Okay, switching back to the other side of the coin, another potential pro or benefit, depending on how you look at it, is that most income annuities don't have to be annuitized. And often aren't nowadays. Annuitizing refers to the fact that when you give the insurance company the money to purchase your annuity, you give up the access to that lump sum in exchange for guaranteed payments, often for life. Again, if we look at something like Social Security or a public pension, for example, you pay into them over a long period of time while working. However, once you retire, you don't get the option to take the lump sum of money that you've put in or tap into it partially. They are simply promising you payments for life. You may have paid two to three hundred thousand dollars in Social Security. But if you're single and you pass away before taking it, the government keeps that money. And you can't even have an heir inherit the rest of the bucket, either. Nowadays, most annuities you purchase don't require you to annuitize, and therefore, again, most don't. However, the insurance company will still promise you those guaranteed payments. Therefore, if you were to die prematurely while drawing down your annuity contract balance before it was actually exhausted or you simply wanna do surrender it and get out, you or your beneficiary can receive what's left net of the costs. This component of annuities is crucial for estate planning or for a surviving spouse or children.

One of the last potential causes I wanna mention that nowadays is becoming less and less of an issue is cost. I'll caveat that I am not going to get into the nitty-gritty details of the potential costs of all the different types of annuities in today's episode, but rather a general overview. We will save the minutia for a future episode. There's just too many different types of annuities and potential cost structures out there. Annuities historically have been a fairly expensive investment product. And this is surely what you're going to read about if you begin to research them online. This has been mainly due to the fact that the insurance companies are providing possibly very rich benefits and guarantees compared to other investment vehicles that have no guarantees at all. I say possibly because if, in fact, you beat the averages and live a long life, they can be on the hook for a lot of money. However, there are many different cost components to some annuities that don't relate to the actual guarantees of the insurance companies that can become cost prohibitive such as underlying investment costs or implied costs.

0:20:37 The exact cost that you pay on an annuity will depend on the exact type of annuity that you purchase and the insurance company offering it. That being said, here are some of the most common examples of income annuity structures or types, all of which can have varying degrees of costs and cost structures. And the first I'll mention is the single premium immediate annuity, deferred fixed annuities, variable annuities, and fixed indexed annuities. Each of these types has different cost components in use cases. The important thing to know is that some cost less than others but usually will have different features or guarantees because of the cost difference. And because these are offered by insurance companies that compete in the business marketplace, costs have been driven down over time, which is great for you. In today's annuity marketplace, there are many very competitively priced options when compared to the benefits and value they can provide retirees who require them. When it comes to fees or costs with annuities, I will summarize it with this.

You should only pay for things that you value. If you value peace of mind in having an income stream that you can't outlive or value reducing the longevity risk, specifically in your retirement income plan, or reducing the risk that bonds in their yields don't match your spending needs over a thirty-year period, then you may consider paying a higher cost for an annuity in some way, shape, or form. If you don't mind longevity risk and are a hundred percent confident in your retirement income plan, and therefore don't place so much value on managing risks, then maybe you shouldn't consider an annuity. With anything insurance related, you may end up paying more than you needed to for something if the risk you're protecting against never presents itself. Similar to car insurance or homeowners insurance, for example, you pay premiums, but if you don't use it, you essentially lose it.

0:22:31 Income annuities can be thought of as insurance for your retirement income. If you purchase an annuity because you get spooked out of the stock market immediately after a crash for some other guarantees that are not income related, such as protecting that money against some level of downside performance on your would-be stock market investments, you will pay more than many alternatives for that potential benefit. And if the downside market risks that you fear don't actually materialize over time, you would have likely been better off just investing in the markets versus an annuity or investing in things like stocks or bonds, mutual funds, etcetera. You would only consider implementing an annuity as part of your plan if you are trying to protect against a certain risk that is actually material to your situation. If you have looked at everything holistically and determined that you don't have longevity risk in your plan for one reason or another, then there is probably no need to look into an annuity to ensure that risk. Another risk you might compare to the value an annuity may provide might be the fact that without one, you must be able to consistently produce reliable income from your other investments for as long as you live. This risk is a combination of your own behavior and due diligence, as well as interest rate risk, which will affect the income you're bond or CD investments, can produce.

0:23:57 Now, I have one more con that I want to quickly mention, and it has nothing to do with annuities themselves but rather the way in which they are sold. Annuities, at their core, are insurance products. They are not stock market investments or direct bond investments. Therefore, they can be sold by insurance agents or financial advisers with fairly limited licensing and sometimes sold for the wrong reasons. I mentioned this because if you end up considering an annuity as part of your retirement plans, have a good understanding of who you're getting your information from and what they are proposing. Some professionals are only licensed to provide certain types of annuities or products, while others can offer most products. Some don't offer them at all. Some professionals are what we call captive agents to an insurance company that will only allow them to sell that company's annuity or insurance products. Which may not be the best for you or even comparable to those available outside of that particular company. Therefore, I urge you to ask questions, a lot of questions before engaging in the annuity research process. Okay. So what is the primary reason why someone would consider an annuity in retirement?

In my professional opinion, certain types of annuities, such as those that fall under the umbrella of deferred income annuities, should be considered as a potential bond replacement for retirees who have longevity risk, specifically in their retirement plans that are not already covered by other forms of guaranteed income such as Social Security or other pensions. And to understand how to determine whether or not you have longevity risk present in your own situation, refer to my previous episode about building a retirement income plan, which I will add a link to in the show notes of today's episode. Annuities should also not take up a significant portion of a retiree's overall net worth. Remember that. Why should they be used to potentially replace some of your bond investments? This is primarily due to the fact that the interest rates bonds pay rely heavily on the prevailing interest rate environment. If you require your income ten years from now to grow at three to four percent to keep up with inflation, but you can only purchase bonds in the current environment that pay, say, four percent for five years, then there is a risk that the prevailing interest rates may be lower at the end of the fifth year. This means that you may need to reinvest at lower rates for the next five years at rates that won't keep up with your spending needs.

0:26:29 There's no way to know what investments, such as government bonds, will be paying in a given year or how stocks may perform over a given set of years. I will caveat, however, that annuity rates also depend on the prevailing interest rate environments. However, this can be part of the benefit of a deferred income annuity. By deferring for a given period of time, the insurance company is usually guaranteeing you some sort of growth of your future income payments, either through a rate of return or growth in the withdrawal rate you may use in the future. This can help insure against this issue. You will know what those minimum guarantees are when you purchase the annuity so you can do your planning accordingly. In addition, by having certain guarantees and knowing what a particular minimum income benefit may be in future years, it theoretically allows a retiree to take more risk with their, let's say, stock market investments, which tend to have higher probabilities of positive performance over longer periods of time such as ten to thirty years that typically also outpaces inflation. Many investors constantly change their stock allocations depending on what's happened recently in the stock markets, and as we already know, this can cause great harm in the long run to a retirement portfolio's longevity.

So as you have probably guessed, annuities aren't black and white necessarily, nor are they particularly good or bad. Yes, some are good, and some are bad. Some good annuities can even be bad for a particular retiree, given their situation, such as someone who doesn't need one to begin with. The key with annuities is to know what they should be used for and that they should be considered in the context of one's entire financial life, including a potential spouse. Many factors will weigh on the decision on whether or not an annuity should be considered as part of your retirement.

0:28:26 That's all for today's show. If you have more questions regarding annuities, feel free to ask me a question directly by visiting retiredishpodcast.com/ask a question, which I will provide the link to in today's show notes, and I will address it anonymously on the show since more than one of you will likely have the same question. If you have a minute and find this information actionable and insightful, and you wanna stay up to date on the latest and useful retirement planning content, please subscribe to or follow the show on your podcast app. If you'd like to learn more about the rules and strategies discussed in today's show, you can find the links to the resources we have provided in the show notes on your podcast app, or you can visit us at retiredishpodcast.com/16. There, you can also sign up for our monthly Retired-ish newsletter, where each month, we discuss money and emotions, investing, tax, estate tips, Medicare and Social Security, and even a brief discussion about the current markets in layman's terms. We always include something actionable in our newsletters so that you can implement things right away, such as how-to guides and other simplified strategies. Again, this can all be found at retiredishpodcast.com/16.

Thank you for tuning in and following along. See you next time on Retired-ish.

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