I recently helped a friend evaluate an annuity product that he was considering for part of his retirement savings.
Like many of us, he wanted to protect some of his assets from gut-wrenching stock market volatility. He also wanted to ensure that he will have sufficient income when he decides to retire in a few years.
His financial advisor had proposed an annuity product—the fixed-index variety—that would provide lifetime income, downside protection, and the potential for some of the stock market’s upside.
Fixed-index annuities have their growth tied to a stock market index (such as the S&P 500) instead of prevailing long-term interest rates (which is typical of deferred annuities and single premium immediate income annuities—SPIAs). They typically carry floor and ceiling limits, hence the reference to downside protection and the possibility of some market gains.
These products are often sold with “lifetime income riders” (at an additional cost) that provide the lifetime income guarantees, regardless of what the stock market does.
My friend is an intelligent guy, but like so many who get these kinds of proposals, he was having trouble making sense of it. That’s because they tend to be very complicated (i.e., lots of small print); I had to spend quite a bit of time reviewing the recommendation myself.
This wasn’t the first such proposal I’ve looked at, and in my opinion, the product itself wasn’t a bad one—in fact, in many ways, it was better than most.
My main objective wasn’t to tell my friend whether to buy an annuity or not. Rather, it was to help him fully understand his advisor’s proposal. I wanted to make sure he had the whole picture so that he could make an informed decision.
Are annuities biblical?
As far as I know, annuities are not in the Bible. But neither are a lot of the modern financial instruments that we have access to today. And I don’t think buying an annuity violates any biblical principles. However, as with all such things, we must guard our hearts and not look to anything—annuities included—as our ultimate source of retirement security.
I recently read this quote from a sermon delivered by Kevin DeYoung:
If there is one balloon the Bible is constantly popping, it is the myth of financial security. It is a lie to think that we can ever, apart from the Lord, be truly secure.
I wholeheartedly agree with that statement. As DeYoung later points out, God understands our intrinsic desire for safety and security for ourselves and our families. But he reminds us that the Bible continually challenges all of our attempts at finding our ultimate financial security in anything but God. Real security is not financial; it is the security we have in the merciful saving love and grace of God.
But I don’t think our ultimate dependency on God negates the need to wisely steward whatever resources God has entrusted to us, including our retirement savings. Annuities can, therefore, be something that God has given to us by his common grace to help better steward the money he has given us. We have a choice whether to use them or not. And regardless of what we decide, we are no less dependent on God.
Taking a fresh look at immediate annuities
Annuities are an undeniably important part of the contemporary retirement planning landscape. I have been reading about and studying annuities for several years. I have also written about them in the past. It’s been a while and my discussions with my friend prompted me to start thinking about them again as a possible addition to my own retirement income plan.
I am not a financial advisor or insurance professional, and certainly no expert on annuities. I am just a retired IT guy who is trying to figure out whether they make sense for me or not. You may be in the same boat (or perhaps you will be in the future).
I do, however, have a pretty good understanding of where annuities might fit into someone’s overall retirement plan. My perspective is that they are most useful in “filling the gap” between guaranteed income sources such as pensions and Social Security and the less reliable income from a risk-based stock and bond portfolio (what is called the “floor-with-upside” strategy). Annuities can be useful in helping retirees to establish a stream of income for retirement that they won’t outlive. They can also be a good strategy for those with fewer savings to maximize their income.
My starting out retirement income strategy has been to combine income from a conservatively invested, income-oriented, stock/bond portfolio with the Social Security benefits my wife and I receive. Therefore, Social Security is the “guaranteed,” inflation-adjusted component, and my investments—which are heavily weighted toward dividend-paying stock and bond funds—are the riskier portion.
At this point, I am only considering immediate-income annuities, which are different than the fixed-index annuity product my friend was proposed. They are not investments, per se’—they are best described as “longevity insurance” whereby you hand an insurance company a lump sum, and they contract to pay it back to you, as principal and interest, usually in fixed monthly payments, for as long as you (or your surviving spouse) live.
I will take another look at fixed-index annuities in the next article. I will also explain why I currently have little or no interest in the third kind: variable annuities.
Annuities as a bonds-replacement strategy
Many people, like my friend, initially think of annuities as a way to tamp down the stock-market volatility in their retirement portfolio. But rather than focusing on stocks, some respected retirement planning professionals suggest that annuities are better used in place of bonds as a way to generate reliable, lifetime retirement income.
Others who are less fond of annuities say that a bond or CD “ladder” can accomplish the same thing.
Since I have already reduced my allocation to stocks, which is currently in the 35% range, I might be interested in an annuity as a more reliable replacement for some portion of the bond fund/cash component of my investment portfolio. It currently stands at about 65%. So, for me (and perhaps for others), the question seems to come down to this:
Is some kind of an annuity a better choice than individual bonds and/or bond funds as a more stable and reliable source of income in retirement? And if so, what kind of annuity should I buy?
To be able to answer this question, I need to look at the two most important aspects of each: risk and return.
Bond returns depend primarily on prevailing interest rates. Short-term rates, which in the U.S. are based on the Fed Funds rate (the interest rate the Federal Reserve Bank charges commercial banks), are usually lower than long-term rates. They are also more volatile.
As we all know, interest rates are currently low and have been so for quite some time. Therefore, short-term bonds are paying around 2%, and longer-term bonds are paying between 3 and 4% (not a huge difference). (Long-term Treasuries are currently paying even less.) Compare this with 20 years ago when they were in high single digits.
So, a mutual fund like the Vanguard Total Bond Index Fund (VBMFX), which is classified as an intermediate-term bond fund, currently pays out 2.5%. The Vanguard Long-Term Bond Index Fund (VBLTX) pays a little more at 3.33%. I don’t own either fund. For the corporate bond portion of my portfolio, I mainly use PIMCO’s actively-managed bond ETF (BOND), which is currently paying about 3.5%, and iShares’ 0-5 Years Investment Grade Corporate Bond ETF (SLQD), which delivers 2.75%.
I also use the iShares TIP ETF to invest in inflation-protected Treasuries. And for the safer “cash-like” portion of my portfolio, I use the iShares Short Treasury Bond EFT (SHV), which pays 2.11%.
Based on my allocations to each, I figure my average return (interest only, not considering any capital gains or losses), is about 2.5%, which matches VBMFX. Not very impressive is it. But then I am relatively conservative in my bond fund investments. So what if I use an immediate-income annuity instead?
This is where things get tricky because immediate annuities don’t pay interest in the same way that bonds and bond funds do. They distribute your principal back to you with interest while guaranteeing those payments for as long as you live. This can work to your advantage because the insurance companies use your money along with others to create “risk pools.” And since they know that some percentage of their annuitants will pass away before they get all of their principal back in the form of “guaranteed” payments, they can pay what is called “mortality credits” (which is basically a bonus for living longer).
These “mortality credits” are a crucial feature of income annuities because the payouts are based on longevity averages (as defined in actuary tables). That essentially means that the money not paid to those who die sooner can be used to pay those who live longer. So, the longer you live, the more mortality credits you receive. The greater your credits, the more likely you are to get more back than you originally put in.
I went to immediateannuities.com, an online annuity broker, to get a quote for a joint, 100%-to-survivor, annuity for my wife and I. I also wanted the option for some portion of the remaining premium to be paid to our beneficiaries if they offered it. To my surprise, the quote I received had a cash flow (or payout/payback) rate of 5.83%! That is about double the interest income I get from my bond funds. At that rate, I would get all my money back in about 17 years (by the time I am 84 years old).
But this is not an apples-to-apples, or even an apples-and-oranges, comparison. Annuities return both principal and interest, but I am NOT currently withdrawing principal from my bond funds; all of the money stays in my account, invested however I choose. Therefore, in theory, I could invest my money in basically the same things the insurance companies do—long term, high-quality bonds currently paying around 3.5%—and, assuming the bond fund prices and interest payments remain constant (which they don’t), withdraw 5.83% myself. If I did that, I calculate that I would run out of that money in about 23 years (when I am 90 years old).
Should bond prices fall dramatically during that period (due to adverse economic conditions or rising interest rates), I could run out of money much sooner unless I withdraw less. The distinct advantage to an annuity is that I would never run out of money, even if either my wife or I live to be 100. This is made possible by the “mortality credits” I mentioned earlier.
What about risks?
Contrary to what many people think, bonds and bond funds have risks, most notably, credit and interest rate risk. Corporate bonds are somewhat riskier than Treasury bonds that have the backing of the U.S. government, and foreign bonds tend to be viewed as riskier than domestic ones.
Credit risk is the possibility that a company will get into financial trouble and default on its loan obligations. (This is reflected in the companies’ bond ratings: AAA, AA, BB, etc.) This risk can be mitigated somewhat by investing in “investment grade” bonds and diversifying across different companies and industries.
Interest rate risk has to do with the impact that a rise in interest rates (such as the Fed Funds rate) has on bond prices: when interest rates go up, bond prices go down. So, if you are holding a bunch of intermediate and long-term bonds or bond funds, and interest rates rise rapidly, the value of those investments could fall precipitously. (The reason is that they become less valuable to investors who can invest in newer bonds paying higher interest.)
Although annuity payments are said to be “guaranteed,” they also carry some risk. The payouts are only as reliable as the insurance companies that provide them. This is called “solvency risk.” It is similar to the default risk for bonds as it depends on the financial health of the insurer. Although the risk may be somewhat low, especially for highly-rated companies, it is still there. The most significant risk to annuity-based income is inflation.
Since 1990, inflation has averaged 2.46% a year, which is historically low. It was even lower—a paltry 1.8%—for the period 2010 to 2019. (According to inflationdata.com, inflation for the 1970s and 80s averaged 7.25% and 5.8%, respectively.) But even with relatively low inflation, a dollar is worth about 50% less today than it was in 1990! If that pattern continues, a 5.83% annuity payout today would be equivalent to 2.7% in terms of “real dollars” 20 years from now. That is a significant risk—not in terms of running out of money, but relative to how much goods and services your annuity income will buy.
So, if I were going to purchase an annuity, it would make sense to buy one with inflation protection. By that, I mean one with cost-of-living adjustments tied to the Consumer Price Index (CPI). However, to the best of my knowledge, only one company offers immediate income annuities with inflation protection (The Principal Life Insurance Company), so they have little competitive pressure from other companies. And to make matters worse, these annuities also have significantly lower initial payout rates than a fixed-income annuity. (That makes sense since the company is taking on the inflation risk.)
Inflation also affects the interest from bonds. Interest rates tend to rise with higher inflation. However, as interest rates rise, bond prices fall. The best way to mitigate the effects of inflation on bonds is to buy Treasury Inflation Protected Securities (TIPS). According to Investopedia, these are “treasury bonds that are indexed to inflation to protect investors against the effects of rising prices.” (I currently have about 10% of my bond investments in the TIPS ETF I mentioned earlier.)
Inflation also affects the interest from bonds. Interest rates tend to rise with higher inflation. Moreover, although it isn’t an automatic hedge against inflation, a well-constructed stock/bond portfolio will often keep up with inflation over the long term. Not to mention that it would remain 100% liquid (i.e., I would not have to hand over a pile of money to an insurance company.
The bottom line is that both annuities and bonds carry risk, but the contractual guarantees of annuities seem to weigh in their favor, especially over a very long lifetime. To truly take inflation-risk off the table, I would need to either, 1) invest exclusively in TIPS; or, 2) purchase an inflation-adjusted immediate annuity.
Keeping my options open
The immediate income annuity seems to have a decisive advantage over intermediate and long-term bond funds as far as maintaining a stable and reliable income stream for as long as my wife and I live. This is especially true if I want to take longevity risk entirely off the table.
My analysis suggests that an immediate income annuity, when used as some percentage of my stock/bond portfolio—perhaps with an allocation of 30/30/40 or something like that—may be a wise strategy since it would allow me to add to Social Security to increase my guaranteed income floor. But historically low interest rates, lack of inflation protection, and having to part with a big chunk of cash all at once, tend to deter me from pulling the trigger on the annuity-for-bonds strategy at this time.
Does not mean I would never purchase an immediate fixed-income annuity? No, but if I did, I would probably look for a good inflation-adjusted product. Or, I might build an “annuity ladder.” These options make the most sense, not only to lock-in a steady income, but also to be able to maintain purchasing power in the future.
What about other types of annuities?
At this point, I want to return to my friend’s situation that I mentioned at the beginning of this article. As you recall, he was looking at a fixed-index annuity, which, according to his financial advisor, offered downside protection with the ability to participate in some of the market’s upside.
I have been wondering: could this be an answer to the inflation problem that immediate annuities have? Should I consider a fixed index annuity, or maybe a variable annuity, instead?
I’ll tell you what I did in the next article of this two-part series.