Annuities: Heaven or Hell?

Economist James Brown recently wrote, "A rational retiree should buy a life annuity and an insurance policy that pools the risk of unanticipated health expenses. Retirees aren't buying enough annuities, and they’re also not buying as many long-term care policies as they should."  If this is true, is an annuity heaven?  If it is, then why do so many investment advisors act as if buying an annuity will send you straight to hell?  OK, perhaps I'm exaggerating, but when one prominent investment adviser said, "Never buy an annuity," a prospective buyer could take it that way.

How should a prudent buyer/investor/saver consider annuities?  Who might want to buy one?  AND why won't my investment adviser tell me about them?

Let's answer the last question first.  Here are the common reasons that you'll see to not buy an annuity.

1. They are hard to understand.

2. They are too expensive/have too high of fees.

3. They aren't necessary.

4. Insurance sales people don't give you all the details.

5. Investment advisers usually don't know enough to actually advise you.

6. Investment advisers don't sell annuities so it is in their interest not to recommend annuities. (Advisers who charge an hourly fee are an exception.)

While annuities may not be for everyone, it is interesting that academics tend to favor annuities (and long term care insurance).  Investment advisers often don't.  What can annuities do for you and why would someone want one?

Before I answer that, I admit that some of the downsides of annuities are, or can be, true.  Not all annuities are the same and many companies offer annuities that are expensive, have high fees, and are not competitive.  In addition, some sales people do not explain the aspects of annuities that might be unattractive to a given client.  However, it's also true that most investment advisers don't understand annuities themselves.  This is especially true if they are people who do not have finance degrees, but have simply gone through a personal financial adviser course.  It is also true, just as an insurance sales person gains from selling annuities, that a traditional investment advisor loses when a client purchases an annuity.  So, your traditional investment advisor is not objective. 

The person who is best suited to purchase an annuity is someone who has some or all of the following characteristics:

1. Desires secure cash flow in the future.

2. Does not want to manage investments in retirement.

3. Does not want to be exposed to market fluctuations in retirement.

4. Has a conservative approach to investing.

5. Has a family history of long life.

6. Likes having someone else control cash flow of savings.

7. Doesn't do a good job of budgeting a large sum of money with an indefinite period of future time.

Annuities vary by type, but I'll leave that detail for a future post.  The key is that annuities are not the same.  The client can choose from a variety of options and riders to change the contracts.  The annuity is an insurance contract, not an investment.  It does pay interest, but an annuity attempts to remove as much risk as possible for future payments.  This is especially important if the recent market volatility continues. 

Market volatility is not that important if you have a buy and hold strategy in a market index fund while you are working, but once you retire, volatility can be quite harmful.  The average return of the market is not nearly your actual return in retirement because you are taking money out of your investments frequently with little choice of when you will withdraw the money.  If you have to take a large amount of money out during a market down turn or there is an extended market down turn, then your long term future is put at risk.  

While there are ways to mitigate market fluctuations without an annuity, an annuity does very well in comparison to other "safe" investment.  Few people would recommend that an annuity be a large portion of retirement planning, but it makes a lot of sense as the safe portion of retirement planning. 

One more note for now, the expenses associated with an annuity are relevant to its purchase, but not nearly as much as what your actual returns are.  If I could guarantee you a 15% return (which I can't), but I also made a large commission, you wouldn't care.  You should not care how much your advisor or your insurance agent makes as long as you are being taken care of.  Complaining about commissions is like hiring a cheap and inexperienced investment advisor rather than an expensive but proven investment advisor.  If your outcomes are improved, then the cost is worth it.  The insurance agent and company will make money, but if you shop around and find the best annuity contracts, they may be exactly what you need.  A good annuity may not get you to heaven, but it's certainly better than the hell of hard earned retirement money lost in an extended market down turn.