Jim Lorenzen, CFP®, AIF®
Many people who’ve enjoyed their employers’ guaranteed retirement pensions probably never gave much thought to the fact that some of their compensation was being diverted into an account that would fund the pension – and I’ll bet even fewer suspected that their pension was likely being funded with an annuity purchased by their employer. They would have hated purchasing an annuity themselves; but, they love the pension.
But there is an anti-annuity bias existing among many, if not most, investors. And this is despite the fact that there are certain realities we all face:
- We don’t know how long we will live – we face longevity risk, the risk of running out of money.
- When the ‘bad return years’ will occur (Murphy’s Law) – that’s called sequence of returns risk.
- If and when unexpected financial disasters might occur – health issues, roof and air/heating go kaput at the same time (Murphy’s Law again).
The good news is the use of an immediate or deferred annuity can help solve many concerns, particularly the first two above – the income is for life and market returns won’t affect that income. This is why many refer to their use as a ‘personal pension plan’.
But, there is no such thing as the perfect investment – at least I haven’t found it (and I’ve been looking on behalf of clients for more than 27 years).
Every investment on the planet has a set of characteristics. It’s generally not a question of what’s ‘good’ or ‘bad’; it’s more of a question of whether (or not) the majority of those characteristics are appropriate and beneficial – or whether the majority are inconsistent with the client’s financial situation, as well as his/her goals and desires.
- Sometimes, problems arise when people misconstrue the purpose of an annuity. Instead of focusing on the true purpose (providing an income for life), they often focus on the risk of dying before they receive all their money back. They hate the thought the insurance company might `win’. Despite the fact they hope they’ll never have a house fire (which would allow them to ‘collect’), they forget they’re really insuring against a risk (longevity) in the same way they insure their homes and cars.
- Some focus on ‘returns’, conflating an annuity purchase with a bond. The truth is they’re not purchasing a stream of dividends or interest; they’re purchasing an income stream, i.e. cash flow for life – in effect, a return of principal and interest with one difference: It’s for life; it never runs out.
- Another obstacle appears to be investors’ tendency to misprice the value of a guaranteed income for life. Few understand time-value of money and generally greatly underestimate the amount of money it takes to fund a monthly income for life. No wonder lottery winners tend to take the lump-sum and most people elect to take Social Security at 62.
Almost everyone would like a pension; but, few are willing to fund it – despite the fact that those who do have pensions and Social Security income did indeed fund those annuity payments with about 6% from each paycheck.
When one considers it takes a 25% return to buy-back a 20% loss in the markets, guaranteed income for life can sound pretty good IF there’s a willingness to fund the income stream.
Are fixed annuities right for everyone? No. Nothing is. Some academic research seems to support their use as a portfolio component for those with between $400,000 and $2 million; but, that’s academic theory, which often doesn’t translate well into the real world. Not everyone who fits this profile will have the same family situations, lifestyle requirements, health concerns, goals, yada, yada, yada.
It’s also worth remembering that annuities can be very complex products with a lot of moving parts – something that contributes to investor hesitancy. However, if you decide you want an annuity as part of your portfolio – talk this over with your advisor and be sure you understand how it will fit with your current formal retirement plan (or if it’s even needed) – a few key points are worth remembering:
A retirement annuity is not an investment; it’s a risk-transfer tool. You are purchasing a lifetime income stream and transferring longevity risk to the insurance company. It’s an insurance policy.
A retirement annuity should not be your total retirement strategy – it’s a supplement to your other planning, as well as Social Security.
Do not automatically assume annuities are good. Do not assume they are automatically bad. Simply see if and how this planning component could fit (or not) with your formal plan.
Finally, I can hear someone asking, “Do you recommend annuities to your clients?” My use of annuities in client portfolios can best be described as extremely rare. It’s not that annuities are bad; it’s more that, for one reason or another, they either haven’t been needed or there were other overriding issues that were more important. That doesn’t mean I wouldn’t recommend a particular annuity design if circumstances warranted – it’s just been a rare occurrence up to now.
Annuities can be confusing: Variable annuities are NOTHING like fixed annuities. An annuity linked to a market index is NOT a variable annuity – it’s actually a fixed annuity and it is NOT an investment in the stock market.
If you’re not sure, the best advice is to get professional help. After all, how many of us would stand in front of a mirror with a pair of pliers when we have a toothache?
Jim
Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and an ACCREDITED INVESTMENT FIDUCIARY® serving private clients since 1991. Jim is Founding Principal of The Independent Financial Group, a registered investment advisor with clients located across the U.S.. He is also licensed for insurance as an independent agent under California license 0C00742. The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.
