The subject of annuities brings many different reactions from people. Those who are nearing retirement, and will have their pension plan benefits coming in the form of lifetime annuity are naturally quite pleased with their financial situation. Then there are those who voice the fact that you lose control of your assets when you buy an annuity.
The main agreement appears to be lifetime guarantee in exchange for long term commitment of your assets. There are many different types of annuities, so we will focus on the type of annuity where you pay the entire purchase price at one time near retirement, and receive lifetime guaranteed payments. This is known as a single premium immediate annuity. You put your money in and start receiving payments within a month or so.
Annuities Compared to Stocks
In trying to decide if you should buy an annuity, you need to look at what the alternative would be if you kept your money invested yourself and tried to receive monthly income. Financial Planners will recommend a portfolio of stocks and bonds. Stocks will provide long term appreciation which is not available to an annuity owner.
Any comparisons of annuities to a stock portfolio will be done using stock market performance for the last 20 -40 years. This performance will probably be in the area of 10% return. So the financial planner will tell you that a portfolio of stocks should return approximately 10% over the long term in the future.
The problem is stocks carry much additional risk of losing your principal, and will not produce a fixed income. While you could just decide upon a fixed amount to withdraw each month from a stock portfolio, you are totally at the mercy of the companies in which you invest foregoing dividend payments. There is a total lack of security and risk of loss when looking at stocks for long term pension payments.
If you need to withdraw principal at some point, you risk doing so at exactly the wrong time, which would be during a recession. You still have the control that you wanted over your portfolio, but during these market downturns you will probably wish that you had locked up your money in an annuity.
Annuities Compared to Bonds
Annuities are usually compared with a portfolio of bonds in deciding if the annuity is a good deal. This is a good comparison since a bond portfolio will produce a steady flow of interest payments which can be withdrawn each month as your pension payments. This is also a good investment to compare since it is closer to what an insurance company would invest in when quoting your annuity.
Insurance companies take your annuity premium and invest it in their general account. The general account of any insurance company is the giant fund or holding bin for all income producing assets. It this fund which, by law, backs all the future payments that will be made under all of the company’s guaranteed products, such as life insurance policies and annuities.
Due to the nature of the products and long term guarantees, the general account contains conservative fixed investments. These investments will vary, but will include large blocks of treasury bonds, corporate bonds, private placement bonds, loans and some real estate. Stocks will not be included in the general account or will be a very minor portion of the account.
Theoretically, the insurance company will take your annuity premium and buy a portfolio of bonds. In reality, your premiums merely get added to the general account. But the general account is buying and rolling over maturing investments every day. The insurance company will base its pricing model on the investments that can be purchased that week or month. So the insurance company will actually base their pricing on the movements of the bond markets at any particular point in time.
The comparison of your buying a portfolio of bonds, vs. the interest rates the insurance company quotes to you, is actually a very real comparison. If you can buy a diversified portfolio of short and long term bonds earning a certain level of interest, the insurance company can do the same. Actually, the insurance company’s general account is invested in longer maturity bonds than you would buy. The general account has enough cash and maturing investments to cover short term liabilities so new money coming into the account is usually invested for longer periods.
Your Bond Portfolio vs. the Insurance Company Pricing
If you buy a bond portfolio to create payments over your entire retirement period, you will diversify this into short, medium and long term bonds. You need short term to ensure there is always enough cash to pay your benefits in case interest payments should drop at some point.
Since the insurance company is investing longer term with any new premiums, the company should be able to provide a higher monthly payment than you could achieve with your bond portfolio. Long term bonds normally produce more interest than shorter term bonds. This is normally true and you also get the insurance company guarantee for life.
However, the insurance company needs to reduce their quoted interest rate a bit for safety and to pay for the guarantees they are quoting under the contracts. They also have expenses, which will be higher than those in running your own bond portfolio.
So, what can you expect when getting an annuity quote? The quote you receive as your monthly guaranteed payment will actually be fairly close to the payment you can achieve when investing in your own portfolio of bonds. That’s right, the two numbers will not be that far apart. If they are, you need to look at the types of bonds you are considering buying. Are they lessor quality corporate bonds? Are they smaller company bonds? If so, you may be taking more risk in your portfolio than you should. With the insurance company general account, the assets are invested in fairly high quality, diversified, fixed income investments.
Commitment vs. Guarantee
The question really comes down to your making a long term commitment compared to keeping control over your portfolio. If you are getting a good interest rate quote from the insurance company, and you cannot get much more on your own, why not go for guaranteed lifetime payments? Many financial planners would say that if you can earn almost the same amount as the insurance company, why not keep control over your assets in case your financial situation changes.
This is a great question and the primary decision point that you have. However, remember that you are now entering retirement, and you want security. Even if you have a large portfolio of bonds giving you a satisfactory level of monthly payments, you will always have the nagging feeling that something can go wrong. Some event will cause your bond portfolio to go off track and not produce the desired level of payments 20 years from now.
If you ask any retiree about their greatest worry in retirement, they will say that it is outliving their retirement assets. So there is a psychological advantage to having the insurance company guarantees attached to your monthly payments.
Diversify the Assets
If you can’t choose whether to buy a long term annuity for the guarantee, or build a bond portfolio for the flexibility, then do both. Take a good portion of your assets and buy the annuity. Take the remainder of your assets and build portfolio good quality investments that can give you more asset growth over the coming years. You do not, and should not, have to put all your retirement assets in one investment. Diversifying the assets will give you both the guarantees and flexibility you desire for the long run.
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