One Cheer

Jonathan Clements  |  May 29, 2018

ANNUITIES ARE OFTEN dismissed as costly, complicated contraptions that are more lucrative for Wall Street than investors. And I’m half-inclined to stick with that blanket condemnation, rather than muddy the waters by offering a more nuanced view. I hate the idea that somebody might read this blog and then buy the wrong type of annuity—and end up making a horribly expensive mistake.

Still, I believe there are four types of annuity that can make sense for investors. Some background: The term “annuity” covers a multitude of products. What’s the unifying thread? All commercial annuities are backed by an insurance company. But it sometimes seems like that’s the only thing they have in common.

There are variable annuities where your results vary with the investments you select and fixed annuities where your return used to be fixed, but now can vary thanks to the abomination known as equity-indexed annuities. There are tax-deferred annuities that are designed for retirement savers, and immediate annuities for those already retired and looking to generate income. But tax-deferred annuities are now also used to generate retirement income, thanks to living benefits riders.

Confusing? You bet. Rather than tell you why so many of these are horrible products, let’s focus on the four reasonable choices.

First, if you’ve maxed out on both your employer’s retirement plan and your individual retirement account, and you’re inclined to buy tax-inefficient investments like taxable bonds and real-estate investment trusts, there’s a case for funding a low-cost variable annuity. The term “low cost” is the crucial qualifier here—and all roads lead to Vanguard Group. The total annual expenses on Vanguard’s annuity range from 0.4% to 0.71%, depending on the funds you pick.

Second, if you’ve already delayed Social Security to age 70 and you’re looking for more lifetime income, I would consider an immediate-fixed annuity. Unlike a variable annuity, an immediate-fixed annuity is a simple product with relatively low implied costs. The income you receive depends on prevailing interest rates when you buy, which means immediate-fixed annuities have become somewhat more attractive this year, as rates have headed higher. In 2017, just $8.3 billion was stashed in immediate fixed annuities, a tiny portion of the $203.5 billion that was invested in all annuities combined, according to data from LIMRA Secure Retirement Institute.

Don’t like the idea of a lifetime income annuity, where your early demise would end up enriching the insurance company? That brings us to the third type of annuity I like: charitable gift annuities. These won’t pay you as much income as an immediate fixed annuity from an insurance company, but you’ll help a worthy cause and get a tax break for your generosity.

Fourth, I see a role for deferred-income annuities, also known as longevity insurance. You might buy a deferred-income annuity at, say, age 65 that will pay income starting at age 85. This can take a lot of the uncertainty out of retirement planning, because it frees you up to spend down your remaining savings, knowing you’ll have a regular stream of income waiting for you, should you live to a ripe old age.  You might allocate 15% or 20% of your savings to the deferred income annuity, to cover your living costs from age 85 on. Meanwhile, between 65 and 85, you could gradually spend down your remaining savings, perhaps spending 1/20th in the first year, 1/19th in the second and so on. But as with immediate fixed annuities, deferred-income annuities aren’t exactly flying off the shelf. In 2017, they attracted just $2.2 billion from investors, says LIMRA.

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