An annuity is a financial product that converts accumulated savings into guaranteed income. In a very basic sense, annuities:
- Turn a sum of money into a series of payments or a “stream of income.”
- Guarantee the stream of income over a specific timeframe.
Human Capital and Asset Accumulation
Saving requires earnings, and for most of us, earnings are generated through work.
Human capital refers to our ability to earn income through labor. Human capital is by far and away one of the most important assets on anyone’s personal balance sheet.
Over time, the excess income generated by human capital is saved and invested. This saving and investing process is referred to as asset accumulation, and the pot of money that hopefully accumulates over time is referred to as financial capital.
Annuities and Asset Accumulation
While much of the focus of this buying guide is on generating retirement income, annuities can most definitely play a role in the saving and wealth building phase. In fact, tax deferral is a strong point in favor of annuities as asset accumulation products.
The above said, the tax deferral aspects of annuities need to be examined thoroughly as there have been meaningful changes to relevant parts of the tax code—particularly for variable annuities—over the past decade. In addition, annuity fees and expenses must be taken into account when comparing and considering investment alternatives.
Retirement Income and Asset Decumulation
For most of us, the value of human capital decreases later in life as the ability to earn income diminishes when approaching retirement. Retirement requires most people to think about how their pot of accumulated financial capital will support their income needs during non-working years.
Asset decumulation refers to the process used to convert or “draw-down” accumulated financial capital in order to generate income and support spending needs during retirement. For example, many people accumulate assets through tax-advantaged retirement savings vehicles such as 401k plans and individual retirement accounts (IRA).
The 401k and IRA are useful for building wealth, but they leave their owners with a lump sum or pot of money towards the end of their working years. The reality is that asset decumulation is equally if not more challenging than asset accumulation, and many people these days are left to figure this out on their own.
Annuities can play an important role in the asset decumulation process, but annuities are not the only way to draw-down savings. For example, bonds, dividends, certificates of deposit and systematic withdrawal plans are used to create income from an accumulated sum of money.
Social Security and defined benefit pension plans also provide income during retirement, and they are both similar to annuities in many ways. In fact, an annuity can be thought of as a personal pension plan. A private annuity offers the same thing that the “old fashioned,” employer-sponsored pension plan provides for employees: it turns savings into guaranteed income.
Take Away 1: When you think of annuities think of income that is guaranteed.
Take Away 2: Pension plan such as Social Security are similar to annuities.
Take Away 3: An annuity is like a private pension plan.
