As the debate over annuities’ role in retirement finance has polarized, it has generated a lot of heat but little light.
Annuities are also a gamble.
We don’t want our money to run out before we die, which is why most insurance companies sell annuities. To be sure, this is a compelling sales pitch. A significant part of your wealth is forfeited to the insurance company if you die before reaching your life expectancy, which is the risk associated with annuities.
A portion of your initial investment is returned to your heirs if you die within a few years after purchasing an annuity because insurance companies are aware of this alternate gamble. These annuities have lower payout rates because of the guarantee. This type of annuity provides coverage for the possibility of getting hit by a truck after leaving the insurance company’s office. Still, it does not eliminate the gamble you take when purchasing an annuity.
The risk of outliving your money is exaggerated
The idea that you will outlive your money may be exaggerated. If properly invested, the same amount of money can yield a return that would last for 20 years, or possibly longer, depending upon the type of investment. Only a tiny minority of retirees live past their early 90s. Even investments in T-bills, which yield almost nothing, could last for about 20 years with the same withdrawal rate (from the annuity).
A significant advantage of annuities is that withdrawals are front-loaded.
Investing in an annuity in the first few years after purchase can provide you with higher annual payments than you would receive if you invested the same amount in a government bond and withdrew your RMD each year). Most likely, this situation will reverse itself after several years-around 15 years-when RMDs from the bond portfolio begin to exceed annuity payments.
Hence, their net present values will be similar. It is often a wash from the standpoint of your entire retirement. Nonetheless, annuities have the advantage of front-loading payments. Retirees often splurge on travel in their first years after retirement when they can most enjoy it. However, taking extra amounts from your bond portfolio would be risky since this would increase your odds of prematurely exhausting your funds.
Low bond yields make annuities more attractive
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A little-known feature of annuities is that low bond yields increase their advantage over an otherwise comparable bond portfolio. This advantage is because each year’s annuity payment includes a return of principal. The return of principal, represented by a more significant portion of each year’s payment, will therefore be greatest when bond yields are lowest.
Many people who would otherwise purchase annuities have been discouraged since annuity payout rates correlate with bond yields and have fallen over the last decade because of declining interest rates. In their view, annuities should not be purchased until bond yields (and payout rates) return to their former glory, and annuities would be less appealing if we returned to those days.
During times of high-interest rates, it’s easier for a bond portfolio to beat an annuity. Potential annuitants may be shooting themselves in the foot by waiting until interest rates rise to levels seen in previous decades. Moreover, if they invest in bonds in the meantime, their portfolios would lose a lot of money.