The Top Reasons to Consider an Annuity

Annuities are complex, largely misunderstood, and often misrepresented in popular financial media.

The reality, though, is that these financial products are becoming an increasingly important part of the financial plans of millions of people around the world.  In fact, annuities are a vital component of the retirement planning process.

While the negative aspects of annuities tend to receive broad coverage, there are several fundamental reasons why one should consider the use of these financial products.  The following list highlights the core issues that are addressed through the use of annuities:

1) Longevity Risk: 78.2 million Baby Boomers started turning 60 within the past couple of years, and one of is now turning 60 every 7.5 seconds.  The average life expectancy in the U.S. today is 76.6 years for men and 81 years for women.  A 65 year old male has a 36% chance of living to age 85, while a 65 year old woman’s chances are better than 50%.  These figures continue to improve every year.

Longevity risk is the risk of outliving one’s money in retirement.  This is a huge and growing risk for tens of millions of people all over the world.  The resources required to support longevity are simply not keeping pace with advances in medical technology.     

At the moment, annuities are the only financial product that can effectively deal with longevity risk by providing a source of income that can be guaranteed to last as long as one lives.

2) Sequence of Returns Risk: While the financial crisis has been a terrible experience across the board, it has been especially brutal for people who are near retirement or recently retired.  Near and recent retirees are exposed to something called sequence of returns risk.  This is the risk that a period of negative investment returns impacts one’s portfolio near or during the onset of retirement.  This is the so called “retirement red zone,” or the period during which people are either preparing or actually beginning to make systematic withdrawals from their portfolios.  Sequence of returns risk can have a profound impact on the ability of a portfolio to sustain adequate levels of spending throughout retirement.

The “living benefit” features associated with many variable annuities can be very effective in hedging or eliminating sequence of returns risk—just ask anyone who purchased a variable annuity with living benefits prior to the financial crisis.

3) A Stable Source of Sustainable Income:  Social Security is an annuity—the government provides lifelong income payments that are adjusted for inflation in exchange for contributions made during one’s working years.  Social Security provides the financial foundation for millions of retirees, with tens of millions of Americans reliant on the program as their sole source of retirement income.

Classic or “defined benefit” pension plans are also a form of annuity.  These pension plans—which in the past were often sponsored by an employer—promise an income stream in retirement in exchange for contributions made prior to retirement.

The unfortunate reality is that defined benefit pension plans are becoming a rarity, and Social Security income is not sufficient for most people.

The majority of retirees today have accumulated their financial assets through 401k plans, IRAs and home equity.  As a result, retirees will be forced to make difficult decisions about how best to convert their accumulated wealth into a sustainable stream of income.  In other words, people will be responsible for creating their own “personal pensions” or sources of guaranteed income.  Private annuities fit the bill because they are, in effect, personal pensions.

4) Reduced Complexity and Peace of Mind: Who really wants responsibility for managing their own personal pension program through thirty or more years of retirement?  The process is hugely complex and fraught with risk.  Do you really want to spend your retirement years thinking about asset-liability matching, hedging, derivative programs, interest rate risk, capital markets risk, inflation risk and longevity risk?  Do you have confidence that your financial advisor or fund manager will be able to effectively manage these tasks?

The fundamental financial objective of most retirees boils down to maintaining a standard of living.  People don’t necessarily think about outperforming the S&P and getting richer, they simply want to avoid moving two or three steps backwards in terms of their standard of living. 

Annuities allow one to outsource the responsibility for much of the complexity associated with the management of their personal pension plan.  Why not think about off-loading part the personal pension burden to an institution with scale, expertise, and most importantly a contractual obligation to deliver specific results when it comes to sustainable spending?     

5)  Creating an Optimal Investment Portfolio: The core financial objective for the vast majority of retirees should be to create a portfolio that maintains an adequate and sustainable level of income.  While the notion of stellar investment returns are important and make for good headlines, most retirees are not that concerned about outperforming the Tremont hedge fund index.

Think of annuities as insurance products—similar to homeowners insurance—that help to assure that a person has adequate income in retirement.  The insurance products complement and work with other investment-oriented products in the portfolio such as equities, bonds and alternative assets.

When it comes to using annuities in the context of the overall investment portfolio, the basic considerations are when, how much and what type:

• When to annuitize.
• How much of one’s asset should be annuitized.
• What type of annuities should be used.

Appropriate use of annuities for a portion of one’s assets addresses fundamental retirement income needs and removes major retirement risks—such as longevity and sequence of returns risk—from the picture.  This can actually enable a retiree to be more confident and aggressive with the allocation of the remainder of their assets and lead to a better overall financial picture.