The Error-Proof Portfolio: For Annuities, Timing Is Key

 

This article was originally featured in 2010, but in case you missed it, we are re-featuring it as part of our Retirement Portfolio Week.

Many investors' hackles go up when you say the word "annuity." They immediately think of variable annuities, many of which are pricey and often sold, not bought. (When the TV program Dateline is using hidden cameras to catch salespeople in the act of peddling inappropriate products to unwitting seniors, it's fair to say that an industry has an image problem.)

But plain-vanilla single-premium immediate annuities deserve more respect. The concept is as simple as it can be: You give the insurance company a slice of your retirement portfolio, and the insurer, in turn, sends you back a stream of income for the rest of your life. You can layer on additional bells and whistles--such as survivor benefits in case you die early in the life of the contract--but they will dramatically decrease the payout you'll receive.

The Value Proposition
The idea of using annuities as a slice of retiree portfolios has been gaining traction in the financial-planning community and among mainstream investors during the last few years. Against the backdrop of a rocky stock market and a shrinking number of defined-benefit plans, annuities' promise of a certain payout holds a lot of appeal. And with bond yields still exceptionally low right now, annuities are also attractive in that they generally deliver a higher payout than what a retiree would receive via a traditional high-quality fixed-income investment.

Annuities also help address the more basic problem that--regardless of the market environment--we're all planning for an unknowable time horizon. None of us knows how long we'll live. And increasing life spans increase the risk that a portfolio of stocks and bonds (that is, one without an annuity) might not last throughout a retiree's lifetime, thereby burnishing annuities' appeal.

Problematic Timing
For all of these reasons, it's become conventional wisdom that SPIAs should be part of retirees' toolkits. Unfortunately, fixed annuities are catching on at what could be, in hindsight, the worst possible time. That's because the payout you receive from an annuity is based on two key factors. One is the expected life spans of other annuityholders and the likelihood that some of them will die before the age actuarial tables would suggest. The second is the interest rate that the insurance company can expect to earn on your money.

The first factor--in essence, the fact that some unlucky people in the annuity pool will die before their time--is why annuities can provide a higher payout than fixed-rate investments. In a pool of hundreds of people, the statisticians know that at least some of the folks who should live into their 80s and 90s will expire in their 60s and 70s instead. Those early decedents will have paid more into the annuity than they've obtained from the annuity. Other annuitants, meanwhile, will live well beyond actuarial tables' predictions, enabling them to receive more than they've put into their retirement.

The wrinkle is that people are living longer, and insurance companies are having to spread the money in the annuity pool over more and more very long lives, so increasing longevity will have the side effect of shrinking the payouts for everyone. (As a side note, an interesting body of research indicates that annuity pools include significant adverse selection--that is, the people who are most likely to buy an annuity are also likely to live much longer than actuarial tables would suggest. That may be because those most attracted to annuities may have longevity in their families or perhaps there's a correlation with wealth and better health care.)

That trend will provide a long-term headwind for annuities, but it shouldn't have a significant impact on the timing of when you buy an annuity. The other component of annuity payouts--the interest rate the insurance company can expect to earn on your money--is more problematic. If you buy an annuity today, the currently ultralow interest-rate environment will depress the payout you receive. (It's not a perfect analogy, but it's somewhat akin to buying a long-term bond with a very low coupon. Rates may go up in the future, but you'll be stuck with your low payout.) The average fixed annuity rate plunged from 5.55% to 3.94% between December 2008 and December 2009, according to National Underwriter. That negative rate environment is why financial planner Harold Evensky flatly stated in a video interview last spring that it's a bad time to buy an annuity, even though he thinks the vehicle will be an extremely important part of retirement planning in the future.

What to Do?
For those who like the concept of an annuity but are concerned about the effect of low interest rates on payouts, one possibility is to ladder your investments, essentially dollar-cost averaging in to mitigate the risk of buying an annuity when interest rates are at a secular low. If, for example, you were planning to put $100,000 into an annuity overall, you could invest $20,000 into five annuities during the next five years. Such a program, while not particularly simple or streamlined, would also have a beneficial side effect in that it would give you the opportunity to diversify your investments across different insurance companies, thereby offsetting the risk that an insurance company would have difficulty meeting its obligations.

There are also some annuity products that allow for an interest-rate adjustment if and when interest rates head back up. Such products offer an appealing safeguard to those concerned about buying an annuity with interest rates as low as they are now, but the trade-off is that the initial payout on such an annuity would tend to be lower than the payout on an annuity without such a feature. 

Alternatively, a prospective annuity purchaser could simply wait until fixed-income interest rates head back up toward historical norms, as Evensky suggests. While fixed-income yields have recently begun to climb, they're still extremely low relative to historical norms. 

A version of this article originally appeared April 12, 2010.

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