Why substituting annuities for some bonds could be a smart move

by Leo Almazora08 Feb 2021

While many people view annuities in a negative light, either due to associations with hard-selling tactics or just a misunderstanding of how they work, some economists have found that they can fulfill a valuable function for people in retirement.

According to Wade Pfau, a professor of retirement income at the American College of Financial Services, the most efficient portfolio for retirees is made up of stocks and income annuities, reported the Wall Street Journal. The annuities provide dependable income for life, while the stocks provide growth, a cushion for unexpected spending, and help with legacy wealth building.

The experts’ view, according to the Journal, is that the current low-rate environment makes annuities relatively more desirable than bonds. Annuity payouts may have decreased because of low rates, they haven’t been as hard-hit as alternative fixed-income strategies such as bond ladders.

Bond-ladder strategies, Pfau said, run on a clock. A 65-year-old female retiree with a $1-million nest egg who wants to invest ultra-conservatively, could build a bond ladder where the money would run out when she’s 95 years old, in which case she could earn roughly $42,000 yearly for 30 years given current interest rates. On the other hand, he said using the $1 million for an income annuity would let her get $54,000 yearly from a range of insurers.

The bond-ladder strategy could pay out more yearly than an annuity if it were implemented over a shorter period, say 20 years. But that doesn’t address longevity risk: if the retiree were to live past 85, she’d be out of luck as her income would be gone.

“You don’t have any upside potential with a bond ladder,” Pfau said. “If you live past 85, you’re out of money.”

It should be noted that not everyone can or should spend the same amount of money on annuities. Moshe Milevsky, a finance professor in York University in Toronto, said retirees who already have enough income from employer- and government-provided pensions to comfortably cover their essential expenses may not need a private annuity. After all, someone who buys a basic income annuity means they’d have less money available within their portfolio for emergency expenses.

But people without dependable pension income, he said, could find themselves out of money unless they have an annuity. “You absolutely need to cover your fixed expenses with income that will last for the rest of your life,” Milevsky said. “That’s the floor.”