For many people seeking financial stability in retirement, the guaranteed paycheque provided by an annuity may be very attractive.
Designed to provide regular payments over a certain expected lifetime, annuities are generally misunderstood as investments when they are more like tools against longevity risk, specifically that of outliving one’s retirement savings.
In other words, clients who give up some or all of their retirement savings for the privilege of receiving a cheque each month, typically until they have passed away. While that promise sounds like a solid hedge, there are still flaws that annuity investors must consider.
“In simplistic terms: You could compare using an annuity in your retirement strategy to bowling with the bumpers up,” wrote Wall Street Journal contributor Kevin McAllister. “It can limit your exposure to market volatility as a way to ensure your retirement savings never completely hit the gutter.”
Taking the analogy further, McAllister cautioned that the guarantee of an annuity is no good “if the whole bowling alley closes.” To put it plainly, buying an annuity from an insurance company that subsequently fails can leave retirees exposed. That means they should attempt to predict the financial strength of an insurer decades in the future — a difficult exercise even for professionals.
“Those who are pro-annuity often refer to the relatively-low failure rate of insurance institutions as a point of strength, while those who are bearish are quick to point out the recent AIG scare,” McAllister said.
Another issue for annuity purchasers may arise from the terms of the annuity. Some annuities may offer fixed payments, while others may tie their payments to how well the underlying investments are doing. When those payments are weighed against the money and whatever else a customer gives up in exchange for them, some customers may feel unsatisfied, particularly if they pass away before they expect to.
“[A]n annuity purchase is a sunk cost,” McAllister said. “If your life ends before you expect it to, don’t count on the insurance company to pay out the remainder to your next-of-kin.” He added that through the shared-risk model, the insurance companies are able to subsidize the policies of those who live longer than expected.
Another risk comes from prematurely accessing one’s funds. Those who withdraw from their annuities before turning 59 and a half, for example, can be subject to penalties and taxes.
With the range of annuity variations on the market today, it can be hard for customers and clients to understand, let alone choose, the option that lets them minimize their risks without giving up too much.
“Forget the bells and whistles,” Jonathan Clements, a personal finance columnist for the Journal, suggested. “Instead, consider making a series of smaller annuity purchases over the course of five or 10 years—which you can stop if your health deteriorates.”
Of course, mileage varies for everyone. Personal circumstances, one’s financial situation, and other factors will have to play a part in any decision.