Popular speakers in the financial and retirement space like Ken Fisher and Suzy Orman have made annuities rather unattractive. The major objection has to do with the supposed fees of the product. But did you know many of the annuities available today are not actually fee-based products?
Ken Fisher has high fees, just like other investment options like commodities, hedge funds, and real estate. Some annuities have higher fees than mutual funds but they also come with guarantees, and he’s essentially convincing people to move from those guaranteed products to another high fee fund. There are many types; just like any other asset. So be careful lumping all these tools into one basket!
The Annuity Puzzle
Annuities and Life Insurance are not a religion and don’t require your beliefs. They are both basically risk transfer vehicles. An annuity is essentially a guarantee that you will never run out of money as long as you live. Let's consider the research; not the misinformation and innuendo about these products.
Few financial advisors have made the transition from accumulation to distribution. Distribution requires a different mindset and different strategies. While you are working, a diversified portfolio of stocks and bonds is an efficient way to save for retirement, but once you retire, the rules of the game change and you need to start thinking about distribution. The focus moves from rate of return to income for life; from risk taking to longevity and risk aversion.
So, if annuities are so valuable, why do so few take advantage of them? This has been one of the conundrums of retirement planning for quite some time - it even has a name - the 'annuity puzzle'. “There actually was at least one study where people described the properties of an annuity, and people loved it, up until the time that the ‘A’ word was used, and then they hated it at the same time.” Studies have shown Americans aversion to annuities boils down to three principle complaints:
- Lack of liquidity
- Lack of inflation hedge
- Use it or lose it.
But these products have changed and adapted! The insurance industry has done an admirable job creating a tool that addresses these concerns in a way that satisfies the concerns of the consumer. Most Fixed Indexed Annuities have a 10% annual penalty-free withdrawal, assuaging concerns over lack of liquidity. Furthermore, since the guaranteed income stream is linked to the growth of a stock market index, you have ample opportunity to keep pace with inflation. Lastly, the FIA's death benefit allows one to pass without disinheriting your beneficiaries.
Annuities are another type of pension. As is Social Security. You don't see anyone saying "I hate my pension and so should you." But defined benefit pensions are a dying breed...
"I was once talking to someone from Japan who didn’t understand why, in English, we have these two words, 'annuity' and 'pension,' because they really should mean the same thing."
Wade Pfau, The American College of Financial Services
Sequence and Longevity Risk - Solved
Most advisors still use systematic withdrawals from diversified portfolios or bond ladders to provide income. These investment vehicles subject their clients to market risk, interest rate risk, withdrawal risk, sequence of returns risk, and most significantly, longevity risk. To those advisors, an FRC report by DeMonte and Petrone titled, “Income Annuities Improve Portfolio Outcomes in Retirement” says, “We have proven that even a well-constructed moderate portfolio is likely to fail over the long term if investors get aggressive with withdrawal rates as many will.” What is aggressive? Today, a 4% or more withdrawal rate is considered to be aggressive - and it fails in the face of sequence of returns risk. Morningstar says 2.8% is the safe withdrawal rate in retirement. This means a $1,000,000 portfolio will safely provide only $28,000 annually in retirement. Not very satisfactory! Modern Financial planning requires a 21st century approach.
DeMonte and Petrone go on to say that financial advisors have the obligation of ensuring that their clients have successful financial outcomes no matter the economic storms we face. High inflation, market downturns, and medical advances in longevity are all examples of these storms. My question is a simple one: if a financial advisor does not use a lifetime income annuity, then optimizes the rest of the portfolio to protect against inflation, how can they do that? The answer is they can’t!
The FRC report adds that most investors do not understand the secret sauce of income annuities—namely the mortality credits (think of them as a new form of alpha or investment return). Only life insurance companies can manufacture mortality credits. It is these mortality credits that allow a lifetime income annuity to have such high guaranteed payouts. No other investment can do this. That simply means that you cannot use stocks, bonds, futures, options, hedge funds, or any other vehicle to do what the lifetime income annuities can do!
Here is something interesting: did you know that the life insurance industry has a limited amount of mortality credits and therefore has a limited number of lifetime income annuities it can sell? This was news to me when I was researching retirement alpha! I did not realize that the supply of income annuities is limited. Therefore, in 10 or 15 years, these products may be priced very differently than they are today.
DeMonte and Petrone also noted that this product is perfect for the Baby Boomers who will be retiring in record numbers. Many are coming into retirement with damaged portfolios. They will be seeking guarantees and less risk and will be drawn to the high guaranteed income offered by lifetime income annuities.
For people who tend to shop for the highest payout rate, the FRC report cautions that ratings for lifetime income annuities are even more important than ratings on bonds since you are tied to a life insurance company for the rest of your life. The financial strength of the insurance company should be an important factor in the buying decision. As Babbel has noted in his studies, the financial strength of the insurer is very important. The website SeekingAlpha.com puts it this way, “There are no more guarantees, only guarantors.”
The FRC report found the following about adding a lifetime income annuity to a diversified portfolio: the portfolios that did not contain an income annuity significantly underperformed the portfolios that had a lifetime income annuity. There is a simple test you can do to try to prove all of this research wrong. Take any diversified portfolio (it must have both stocks and bonds), remove some of the bonds, and replace them with a lifetime income annuity. You know what it will do to that portfolio? It will reduce the risk to the portfolio and increase the returns! Here is why: when you add a lifetime income annuity to a portfolio, it functions like a AAA bond with a CCC yield and zero standard deviation or volatility. Try it. See if you can prove me wrong.
In 2018, Roger Ibbotson, the economist known for his Stocks, Bonds, Bills and Inflation chart wrote a whitepaper titled Fixed Index Annuities: Consider the Alternative. He showed that fixed index annuities had outperformed bonds from 1927–2016 and would likely continue that level of outperformance in the future. As one approaches retirement, he says “I’ve always recognized you have to de-risk, and we see that bonds are not necessarily the way to go today.” When added to a portfolio, fixed index annuities can smooth out the returns since they never have a negative return.
In 2019, Dr. Michael Finke and Dr. Wade Pfau wrote a whitepaper for Principal Financial titled It’s More than Money. They said, “For retirees, it’s about more than money. Not only do income annuities provide income that can’t be outlived, they give clients peace of mind and more financial security—something you can’t put a price tag on. By understanding the benefits of using guaranteed income to build a lifestyle, and by providing a clear explanation on the efficiency of income annuities, you can give clients the information to make better choices with their retirement savings.”
In summary, annuities are the only tools which will mitigate against longevity risk - outliving your money in retirement- the #1 fear of retirees. So open your mind. Look at these valuable tools in light of their benefits, and don't fall sway to the popular misconceptions floating around on the Internet. Work with a competent expert in the field and sleep well at night, knowing your bills are paid no matter how long you live.