Why Buy an Annuity

A handful of very large, powerful trends are currently shaping the retirement income landscape:

• Demographics: Lots of people are getting older and reaching retirement. 
• Longevity: People are living longer.
• Volatility: Volatile capital markets can be a retirement income killer.
• Pensions: Social Security and defined benefit pension plans are precarious sources of guaranteed income.

Annuities should become increasingly prominent in the next several years because they effectively address the risks and challenges presented by this combination of major trends.

Demographics

It is a simple fact that the United States and much of the rest of the world is getting older.  As a result, many millions of people are reaching the asset decumulation phase of their financial lives.

^{Source: Swiss Re}

We are at the beginning of a period during which the aging of populations will result in very high demand for retirement income products and services such as annuities.

Longevity

The many millions of people reaching retirement age across the globe are living longer.

Longevity risk is the risk of living longer than one might have expected and running out of money during retirement as a result of the longer lifespan.

^{Source: Wharton Financial Institutions Center}

Longevity risk is one of the most serious financial risks faced by retirees, and annuities are by far and away the best source of protection from longevity risk.

Volatility

Most people keep their financial capital in the form of publicly held securities such as stocks and bonds, or in investment vehicles such as mutual funds that are comprised of stocks, bonds, commodities, etc.

The markets in which stocks, bonds and other securities are bought and sold are referred to as capital markets, and as almost everyone knows after the past several years, capital markets are highly volatile.  In other words, the prices and subsequently day-to-day investment values can fluctuate wildly. 

^{Source: Yahoo Finance}

There are a couple of reasons why capital market volatility is dangerous for retirees.    

First, retirement spending requires a regular, steady stream of income.  Funding a stable stream of retirement income with risky (volatile) assets is wasteful, dangerous and misguided.

Second, experiencing investment losses—the downside of volatility—at the wrong time can be disastrous.  Losses that affect a portfolio at or near the beginning of retirement are especially dangerous because the ability to compound wealth and catch-up to the level of financial capital required to fund retirement spending is greatly diminished.  Sequence of returns risk is the term used to refer to this danger.

Annuities are very useful in light of capital market volatility because:

• With annuities, retirement spending is appropriately funded with a non-risky asset.  In other words, there is a match between the income stream and the source of that income.
• Certain types of annuities and annuity features can be used to hedge or protect against sequence of returns risk.

Pensions versus Annuities

Aside from private annuities, Social Security and defined benefit pension plans are the most common sources of retirement income.

A defined benefit pension plan is the “traditional” type of pension plan that used to be provided by many employers.  It is very different from a 401K as the employer or plan sponsor is responsible for investing and for providing retired employees with pension income.

The problem with both Social Security and defined benefit pension plans is that they are not as reliable as they used to be.

First, defined benefit pension plans are almost extinct:

• The number of pension plans in the United States peaked at 175,000 in 1983. 
• Today there are less than 25,000 of these plans in existence.

Second, the actual rates of return on Social Security contributions are very low—particularly for higher earners:

^{Source: Wharton Financial Institutions Center}

For many people, Social Security and traditional pension plans will not provide a sufficient foundation or floor of guaranteed retirement income.  These people will have to consider supplementing their floor of guaranteed income with private annuities.