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Annuities Receive a Bad Rap

By Dr. Gerald House

MON FEB 01, 2021

Annuities Receive a Bad Rap

The financial service industry enjoys a dominant following of investors who oppose employing annuities in their investment portfolio. Unscrupulous insurance agents who sold inferior annuity products inflicted this reputation upon themselves. Insurance agents brought about this poor record regarding annuities because they took advantage of the less informed investor, hoping to capitalize on higher returns. High commission annuities (think variable annuities) only compounded the skepticism among investors regarding annuity insurance products. Nevertheless, a second look at annuities is warranted.

Financial advisors remain divided about investing in annuities; therefore, they fall into two camps. First, some advisors hate annuities claiming the commission is too steep on selling annuities. These advisors also point out they can sell stock products that produce a greater return (this is debatable). The second camp of advisors believe adding annuities to a diversified investment portfolio will add longevity protection for the client. These advisors typically opt for either a fixed income annuity or indexed annuity (a later discussion topic). Which camp is winning the debate? Contrarily, who is on the right side of the argument?

The answer to the first question above is the first camp of advisors are currently winning the debate. Many financial advisors are "old school" and do not readily change their traditions. These advisors usually got their start in the broker-dealer wirehouse environment where sales of investments were the norm. Therefore, they succumbed to the broker-dealers' Kool-aid propagation that any insurance product was inferior to stocks and bonds—especially annuities and whole life insurance. Unfortunately, this mindset left many baby boomers struggling to extend their 401K and IRA money beyond what they initially planned. Fortuitously, annuities are gaining popularity among the second camp of younger financial advisors—especially after the 2008-2009 financial crisis.

Aside from the fact that the first camp of advisors is winning the debate, are they on the "right" side of the argument? First, what other products include longevity risks besides annuities? Longevity risk is the risk of running out of money during one's lifetime. Second, what amount of money needs to be invested in stocks and bonds to equal the payout period provided by annuities? Dr. Wade Pfau tackled this annuity mystery in his recent article "Why Do Economists Say There is an Annuity Puzzle" (Pfau, W., PhD. 2020). Dr. Pfau determined it would take 90% more wealth (using the flexibility of 10—see his graph) to provide the same annuity equivalent wealth if you do not annuitize. This study analyzed retirees' spending habits using a scale from 1 to 10, with 10 being the highest spending limit. This same study concluded that a $100 invested today would produce a lifetime payment of $5.66 a year using an annuity. However, the same $100 invested in stocks only paid $2.86 for a lifespan of 35 years. Annuities spread the mortality risk among their population. Naturally, in a real-life scenario, the stocks should increase in value, leaving a higher payout, but that is no guarantee.

In the above scenario, the second camp of advisors appears on the "right side" of the debate allocating part of the investment portfolio to annuities. When is the best time to invest in annuities? Additionally, how much of your investment portfolio should you allocate to annuities? First, the benefits of annuitizing, at least a part of your income, make sense. However, suppose an investor annuitized too soon. In that case, they may lose the flexibility (annuities are permanent decisions) to optimize their investments, suffer a health crisis demanding more liquidity, or prematurely die (Pfau, 2019). Another quandary requiring personal attention is the optimum time to annuitize. Unfortunately, deciding the ideal time to annuitize requires a complete analysis of an individual's financial situation. There are too many variables to consider, such as the health of an individual, the income shortfall needed at retirement, and an investment plan for more income in the early years of retirement to cover travel expenses or assist children or grandchildren. Your financial advisor can evaluate these concerns.

Gerald House DBA

References

Pfau, W. D. (2019). Safety-first retirement planning: An integrated approach for a worry-free retirement. Vienna, VA: Retirement Researcher Media.

Pfau, W., Ph.D. (2020, August 12). Why Do Economists Say There is an Annuity Puzzle? Retrieved February 01, 2021, from https://retirementresearcher.com/why-do-economists-say-there-is-an-annuity-puzzle/

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