Is it the Right Time for Annuities?

Christine Benz:

Hi, I'm Christine Benz for Morningstar. Do today's low yields embellish the case for annuities as part of retirement plans or take away from it? Joining me to discuss that topic is David Blanchett. He is head of retirement research for Morningstar Investment Management.

David, thank you so much for being here.

David Blanchett:

Thanks for having me.

Benz:

Let's start with just a really basic question about annuities. There are so many different types that it's almost unhelpful to call them all "annuities." What are the commonalities across various annuity types?

Blanchett:

Are there commonalities? I think the only commonality is the structure of the annuity wrapper. I think that too often the word implies different things. There's annuities focused on accumulation. There's annuities focused on deaccumulation. I spend most of my time focused on what I would call a more traditional annuity, which are those that provide some kind of guaranteed income for life. That being said, most annuities used by consumers today are actually those that are more focused on accumulation. So, it's obviously really important to kind of define the terms as we kind of walk through the topic.

Benz:

I'm hoping you can discuss some of the key pros and cons of using annuities as part of a retirement plan. Many retirees quite naturally are very reluctant to part with a portion of their portfolios. Many annuities are high-cost and quite opaque. Can you run through the basic merits of using annuities as well as some of the things that people might have reservations about?

Blanchett:

Yeah. I don't know that there's any one word that especially gets advisors all excited about annuities. The word itself I think it has a lot of connotations. And when I talk about annuities as those that provide guaranteed lifetime income, one point that I like to make is that the strategy itself has been around for thousands of years. Some kind of product that gives you guaranteed lifetime income. Now, the vehicles to implement that strategy vary in quality significantly. But the one thing that we can kind of all agree on is that determining and figuring out how to provide a lifetime income is really, really challenging, and that's what annuities do best. They simplify the process of figuring out how much you can spend from a portfolio every year. And there's some kind of unique considerations today, especially as interest rates have declined, guaranteed income is actually more valuable. I think that they're always worth considering as part of a retirement income strategy, but an important notice is that the vast majority of Americans already have an annuity in the form of Social Security. So, that's usually the first place you look for more guaranteed income. But if you like the idea of certainty and not having to worry about, "Oh, the markets are down 20%" or "how long I'm going to live," I think thinking about allocating more of your portfolio to guaranteed income, an annuity, a personal pension, whatever you're going to call it, is a smart idea.

Benz:

When a lot of consumers and advisors look at this issue, if they're objective, a lot of times they go immediately to the very basic income annuities, whether immediate income annuities or deferred income annuities. Is that a good starting point, do you think, for people who are interested in adding some level of guaranteed income to their retirement plans?

Blanchett:

I do. Single premium immediate annuities, or SPIAs, have been around, like I said, for thousands of years. They're relatively straightforward. You trade a lump sum for some amount of income that starts effectively today--that's why they're called "immediate"--for as long as you live. There's also products called "deferred income annuities," where you give the insurance company money today and then at some future point in time they start paying you for life. Why I think that's a really good place for folks to start is because they're very easy to compare. You can go online. There's lots of websites you can use for free that will give you quotes on the payout rates of different annuities. So, I give the insurance company $100,000. They'll give me $7,000 a year as long as I'm alive. That's relatively straightforward. There are other strategies that are actually a lot more common where they kind of attach a living benefit rider to a variable annuity or something that can provide actually similar levels of income, but they're also a lot more complex. And so, why you want to start simple is because it's very easy to compare and understand what the payout rates are for products like immediate annuities because you can see it all online.

Benz:

You referenced this very low-yield environment that we're living in, David, and a lot of retirees obviously find that quite frustrating. They can't wring a livable income stream from their portfolios. Annuities are sometimes posited as a way to wring a higher level of income. But I guess one question is, aren't insurance companies behind annuities similarly beholden to the interest-rate environment? So how are annuities able to offer a higher stream of income than you could get by, say, investing in the bond market?

Blanchett:

Sure. There's actually a few interesting points there. Like, the one thing that people don't often understand is that annuities are actually like a relatively better deal when interest rates fall, and it's totally against public perception. But to your point, because payouts are lower, so insurance companies are going to invest in a lot of the same things that you would as an investor, right? They're going to go out and buy bonds. They might be a little bit more exotic, a little bit different. But they're going to buy fixed income that has a lower yield today than it had 20 years ago. But to your question, the one thing that annuities have, and this is kind of the thing with all insurance, is risk pooling. There's this concept of mortality pooling in annuities where, sure, some folks are going to live a long time, some folks live less, but when you add it all together, it actually creates more income than you could generate for yourself if you're creating a safe income stream until, say, age 95. So, it is true that the payout rates on annuities are lower today because interest rates are lower, but it's that other piece, that mortality pooling, that hasn't changed that actually makes them more attractive in environments when interest rates decline.

Benz:

One question, though, is about the timing. I think retirees have been concerned with yields as low as they are and with annuity payouts relating to the current yield environment, I think retirees are concerned, "Am I wise to sink a big share of my portfolio into an annuity product now? Am I locking myself into this lower payout in perpetuity?" What do you say to that, and how should retirees think about that issue?

Blanchett:

To be honest, you kind of are. But interest rates could go back down. I mean, we've been worried about interest rates for a decade, and if you bought an annuity five years ago, it would have been a spectacular decision, right, because rates have gone down a lot since then. And so, the one thing that I would maybe recommend if you're worried about it is to ease into it. Now, a big thing for accumulation is dollar-cost averaging. You buy into a strategy over time. There is a small cost when you buy an annuity, like the underwriting cost, it's going to fix in the purchase price. So, I wouldn't recommend buying one little product every month. But I think if you are worried about where interest rates are going to head in the future, what might happen, buy into it slowly. So, create a strategy where you're not doing one lump sum all at once. But I really do believe that people do need to actively consider guaranteed income as part of their retirement strategy, because if you don't, there's a really good chance you're not going to spend nearly as much because no one knows how long we're going to live. So, yes, I get that interest rates are low, but if you're worried about that now is the wrong time, create a plan where you're going to go in every year and allocate, I don't know, 10% of your portfolio for annuities, something like that, versus just waiting until some future point when you might feel better about the decision.

Benz:

A related question is: We have started to see yields tick up a little bit in 2021. How long does it take for annuity payouts to start reflecting higher yields, especially if we at some point have significantly higher yields come online?

Blanchett:

It works differently for different types of products. But the products that you mentioned earlier on, immediate annuities, those are typically pretty benefit responsive. If interest rates shoot up one day, they're not going to follow suit. But those do move pretty quickly. So, you will see higher payouts today than you would have seen, say, even two or three weeks ago, given where yields have gone.

Benz:

David, such a helpful overview. I know a lot of retirees are really interested in generating lifetime income. It's so great to have you here. Thanks for being here.

Blanchett:

Sure thing.

Benz:

Thanks for watching. I'm Christine Benz for Morningstar.com.