Annuities

An Annuity is a sum of money that is exchanged for the promise of an income stream. It addresses the universal concern of running out of money before running out of breath.

Although this simple concept dates back to Roman times or before, it is tremendously versatile given today's sophisticated financial engineering. Indeed, a problem with annuities today is the overabundance of choice. Almost everything about the basic contract can be modified according to the taste of the person depositing the money (known as the annuitant).

For example, the income stream can start immediately (called an Immediate Annuity), or can be delayed into the future (called a Deferred Annuity). The income can be for life, or for a fixed period. The money deposited can be a lump sum or a series of deposits, and can earn a fixed return or be invested in the market for a variable return. Technically, an annuity is an insurance policy wrapped around an investment.

In each case, the insurance company offering the annuity will quote the income returned each year as a percentage of the money deposited, for example if $50,000 is deposited and the rate is 4%, you will receive $2,500 income per year. Remember, the company offering the annuity must cover expenses (including sales commission) and their profit. 

On the plus side, investment gains grow tax deferred within the account, and the insurance company bares some risk. Many contracts provide income for life, so if you live beyond the expectations of the actuarial tables, you will receive more money than the company planned to pay out. They take this money from the deposits of people who lived for less than the expected number of years in the table. Another risk that the insurance company will take on is the investment risk - on certain types of contract, they will guarantee a conservative rate of return. The insurance company employs large numbers of very competent mathematicians to ensure they won't loose out on the deal.

Annuitization, the process of converting a lump sum to an income stream, is not popular with most people. A lot of us don't like to give up our money now for a promise of money in the future, involving complex calculations of the present value of the income stream, and the fear that the insurance company might become bankrupt and unable to meet its promises. There's an old adage, "There are no guarantees, only guarantors". Will the guarantor, the insurance company, last as long as the annuitant is likely to last? This is not a question to be taken lightly.

However, annuities represent a flexible financial tool that can be very useful in retirement planning. For example, a retiree couple might want to cover their basic living expenses with annuities, and then use their remaining savings to support discretionary spending. They know that their basic standard of living is covered for life and removes fears of destitution in their old age.

You already have the best annuity around - Social Security. In the future, Social Security benefits will become increasingly valuable due to their tax-favored status, inflation protection, survivor protection, and longevity protection. However, a concern about most other annuities is that they are not indexed to inflation, so that over time the value of the income stream is eroded. After 25 yrs of 3% inflation, the value of their income will be cut in half. Should there be higher inflation for a period, the reduction would occur sooner. As you can imagine, asking the insurance company to take on the inflation risk is going to reduce the income percentage they will give you.

One way we work with annuities at Bay Area Planners, is to reduce that time period by annuitizing later in life. We use the annuity as longevity insurance. The idea is that if you annuitize late in life, say at age 80 or higher, you will receive an income stream that is a much larger percentage of your money deposited. This is basically because the insurance company doesn't expect to be paying out for too many years. Your job is to make them lose out on your contract. Our clients are not average; they do not have average income, do not have average health care, do not have average health habits, and are very likely to outlive the average life expectancy. So we think it’s a good bet.

There are two ways to buy such an annuity, either by paying a relatively small amount now to protect you 20 or more years in the future (called an Advanced Life Delayed Annuity), or to wait until you are in your eighties, and then re-evaluate the decision, taking out an immediate annuity if your health warrants it.. Either way, you can use the Bucket System to provide your income up to that age, and then eliminate the remaining longevity risk using an annuity.

One last comment on longevity risk - the demographic impact of the Baby Boomers retiring will affect the ability of financial institutions such as insurance carriers to assume ever-increasing amounts of longevity risk. Each day the gap between present capacity and future needs grows wider, threatening the retirement security of a generation of Americans. Insurance companies will re-price risk if and when they need to (remember all those mathematicians they employ). This is something we will be monitoring carefully.

If you have questions about annuities or the way we incorporate them into our retirement planning, call (408) 725-7135 or click here.

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