Is the Time Right for Annuities?

Key Takeaways

• An annuity is a contract with an individual and an insurance company, where you give the insurance company a portion of your portfolio and investment, and they send it back to you as a stream of income over some predetermined period or over your whole lifetime.
• Payouts tend to get better during a period of rising interest rates because when the insurance company takes in these funds from people purchasing annuities, they have to invest them somewhere in order to make the eventual payouts.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. As yields have risen, some retirees may find that annuities are more compelling options for retirement income than they've been in a while. Is it the right time for you to consider an annuity? Joining me to discuss that topic is Christine Benz. Christine is Morningstar's director of personal finance and retirement planning. Thanks for being here, Christine, nice to see you. Christine Benz: Hi, Susan, great to see you.

Dziubinski: So, let's start out with the basics. What is an annuity, and who might want one?

Benz: There are so many different varieties of annuities that the term itself is almost useless, when I think about it. But at its most basic, an annuity is a contract with an individual and an insurance company, where you give the insurance company a portion of your portfolio and investment, and they send it back to you as a stream of income over some predetermined period or over your whole lifetime. So, from a practical standpoint, annuities have gotten a lot of attention, certainly in the academic community, a little less from actual people, but academics really like how elegantly annuities address people's need for lifetime income. Many of us have Social Security that we'll be bringing into retirement as a source of cash flows, lifetime cash flows. But beyond that, we don't have anything like that. Annuities are a way to augment those cash flows from Social Security, a way to supply consistent guaranteed lifetime income, which is something that you're not going to get from any investments that you might make in your portfolio. Dziubinski: Right. Christine, now we've entered a period of rising interest rates, which we haven't seen for a while. How are fixed annuities affected by rising rates? Benz: Well, positively. Payouts tend to get better during a period like the current one, in part, because when the insurance company takes in these funds from people purchasing annuities, they have to invest them somewhere in order to make the eventual payouts. And they have to, generally speaking, keep the money pretty safe. When higher yields come online, that translates into a higher payout that they're able to promise people who are purchasing the annuities. So, it's been a good effect for people who are in the market for annuities. Dziubinski: It's obviously a plus, but let's talk more in dollar terms. Can you give us an example of how this last round of interest rate increases affected annuity payouts? Benz: Yeah, I wish there were some historical receptacle of information about how annuity payouts have changed, but I did happen to have an example from just back earlier this year of what a 70-year-old who put $100,000 into an annuity would have had in terms of monthly income earlier in the year, in the first quarter. $100,000 for a 70-year-old would've bought $600 in monthly income earlier this year. It's up to $700 now, or $8,400 a year, so a meaningful increase. Dziubinski: Would all types of annuities benefit from these higher yields?

Benz: It's a really good question, and the short answer is probably not. The pure income annuities would tend to be the most direct beneficiaries in an environment like this one, so a deferred annuity, an immediate annuity, any fixed annuity would tend to be a beneficiary. On the other hand, variable annuities, where the person who owns the annuity contract is directing the investment selections, where the funds could be invested in stocks or bonds. Those would tend to behave even negatively in a rising-yield environment, so they would not necessarily be beneficiaries of better yields coming online. Dziubinski: What are the caveats that come associated with annuities? What do people really need to understand and know before they would go ahead and buy? Benz: A lot. I always say, "Ask all your questions before you make an annuity purchase" because it's a big deal. You're entrusting the insurance company with your funds, so you'd need to check up on the financial health of the insurance company. That's really important. If they're going to be backing this product for many years into the future, you need to know that they're in good financial health. You also need to understand how inflation fits in. I would say that's the big knock on annuities is that you can purchase inflation protection on that stream of income, but it'll typically cost you to do so. So just understand the interplay with inflation. And the other key thing to keep in mind is, even though some of the income annuities that we've been talking about are very transparent and generally very low cost, the other annuity types, variable annuities, for example, can be very opaque and also very, very costly. So you really need to understand any costs that you're paying for additional features and bells and whistles.

Dziubinski: Christine, thanks for your time. It's interesting that we are now in an environment where these products that we hadn't really spent a lot of time thinking about or talking about for retirees might actually come into play. Benz: Absolutely. Thank you, Susan. Dziubinski: I'm Susan Dziubinski. Thanks for tuning in.

Watch How to Make Your Cash Work Harder as Interest Rates Rise for more from Christine Benz.