The Wall Street Journal recently had an article about annuities and why so many people should consider them. The most significant reason why annuities are not 100% embraced is simple, people think of them as complicated and don’t understand them.
David Blanchett makes a great case for why an annuity is important in the article below.
DAVID BLANCHETT: Annuities. They’re the Donald Trump of retirement income strategies: People either love them or hate them. Let’s look at whether they can potentially make your retirement plan great (again).
First, the general consensus among financial-planning researchers is that annuities can be good for most retirees. As we move away from defined-benefit plans to defined-contribution plans, annuities provide a method to “pensionize” your retirement savings and are designed to help ensure you’ll have income for life. Despite the potential benefits, few people in the U.S. annuitize much of their wealth (something dubbed the “annuitization puzzle”). The list of likely reasons for not annuitizing includes annuities’ lack of liquidity and how they are often framed (or sold).
What’s interesting, though, is that retirees in other countries seem to be a lot more open to annuities than Americans are. So it isn’t as if everyone, everywhere doesn’t like annuities… it’s just Americans generally aren’t fans.
I think a major problem with annuities is that they are misunderstood to be investments. They’re not. An annuity, like any form of insurance, is a risk-management tool, not a wealth-maximizing product (usually). Most people who buy an annuity are not going to be better off from doing so. If they were, the insurers selling them would be out of business.
Sure, there are going to be winners and losers, but insurance companies are pretty good at pricing risk, so the losers are going to outnumber the winners most of the time. That doesn’t mean that an annuity is a bad thing (no more than life insurance is a bad thing); what’s important is understanding whether you’re someone who should value this form of insurance.
Here are some factors that would tend to suggest you should consider annuitizing:
- You like the idea of a guarantee—you’re someone who seeks certainty.
- You don’t have much existing guaranteed income. The average American gets about half of their retirement income from Social Security. If you’re planning on funding your retirement income from your portfolio, you’re generally a better candidate for annuitization than someone who gets most of their retirement income from other forms of guaranteed income (like defined-benefit plans or Social Security retirement benefits).
- You’re in good health and have a family history of longevity. This one is kind of a no-brainer. The longer you’ll live, the more the annuity is going to pay off.
The best way to “annuitize” your wealth today is to delay claiming Social Security benefits. It’s not possible to get a higher payout from an annuity you’d buy from a private insurance company when compared to delaying Social Security benefits. There’s also the added benefit of things like favorable taxation and a higher potential spousal survivor benefit.
If you’re interested in an annuity, though, I generally think about them in three primary buckets:
- An annuity where the income level is fixed and starts right after you buy it (also called a single premium immediate annuity).
- An annuity where the income start is fixed and starts in the future, such as 10 years from now (also called a deferred income annuity).
- An annuity where the income will vary based on the performance of some portfolio (also called a variable annuity with a guaranteed lifetime withdrawal benefit).
Each of these three types could potentially work for you; the key is understanding how it fits into your overall retirement plan. Overall, though, I’m a fan of simplicity: You need to understand how the annuity works and if you don’t it’s probably a bad fit. It’s also important to shop around to make sure you’re getting the best deal.
Everyone is different and, therefore, the potential benefits of an annuity are going to vary significantly by individual/household. It’s impossible to guarantee income for life from a portfolio; therefore, so as you reflect on how to build your retirement income plan, it is worth at least considering annuities for your “vote.”
David Blanchett is the head of retirement research for Morningstar Investment Management.