How to Earn Income for the Rest of Your Life: The Good, Bad, and Ugly of Annuities

It wasn’t long ago that employees were rewarded for their loyalty to a company with a pension. For you younger readers the word pension may seem like it’s from a foreign language. It’s true, and in recent years the classic pension plans have been dwindling. Pension plans had a very unique feature that most retirement plans today lack: income for life. That’s right, most pensions were set up to pay you each month for the rest of your life, regardless of how long you live.

That’s a great benefit, right? This feature is what made pensions so attractive. While the actual dollar amount might not be enough to enjoy a lifestyle of the rich and famous, the fact that you could depend on this check coming in the mail every single month for the rest of your life made up for that. For many retirees, after factoring in social security and pension payments there was little need for additional savings since these two gaurnteed monthly payments were sufficient for paying the bills. But with pensions going the way of the dinosaurs what options do younger generations have for creating income for life?

The Role of Annuities

You’re seeing more annuity advertisements these days targeting baby boomers. Insurance companies realize that especially in this economy many retiring baby boomers are wishing they had some form of guaranteed income if they don’t currently have a pension. While it’s true that annuities can in fact provide lifetime income it’s important to understand the different types of annuities, features, and drawbacks.

How Annuities Work

An annuity is a simple concept. Generally, you take a lump sum of money and deposit it into the annuity acount. Then, if you choose to annuitize it, you begin receiving a regular payment (monthly, quarterly, annually, etc) that continues for the rest of your life. As simple as that concept is to understand, these products are actually far more complex than this.

First, you have two different types of annuities: fixed and variable. A fixed annuity is pretty much just what it sounds like and it earns a fixed rate of interest. While the rate may be fixed, there are often situations where the rate can change. For instance, there may be a first year bonus rate that pays out higher interest, rates could change from year to year with a minimum or floor rate that it can’t go below, and so on. But what’s important to note is that this rate is really only important before you annuitize the money. That is, you can deposit the money into the annuity and it will sit there and earn tax-deferred interest at the specified rate. Once you annuitize it you lock in that guaranteed monthly/annual payment for life and the interest rate doesn’t matter. And typically, once you annuitize, there’s not backing out of that decision.

Next, you have the complicated variable annuity. Unlike a fixed annuity the variable annuity gives you different investment choices for your money prior to annuitizing. If you wanted, you could deposit money into the annuity and then invest it in any of the investment options available to you within the annuity. Think of it like a 401(k) plan where you have a handful of various mutual funds to choose from. The drawback here is that depending on how you invest your money you could experience a loss in value. This is why it’s called a variable annuity since the account value will vary depending on investment options and market conditions.

Fees and Riders

This is where annuities can end up hurting an investor. First, annuities aren’t free. You probably know by now that virtually any investment out there comes with some sort of fee. Some investments have low fees such as index funds and other funds may have front-end loads and high annual expenses of upwards of 2%. Annuities are no different. When it comes to fees the fixed annuity is the most transparent. You get a fixed rate of return on your money and that rate is already net of fees. The fees can easily be calculated with the documentation provided with the account.

When you start talking variable annuities there’s a potential to get raked over the coals with fees. First, you’re going to have the fee just for having the privelage of owning a variable annuity. This is the Mortality and Expense (M&E) fee that is charged annually. This fee pays for the insurance guarantee, commissions, selling, and administrative expenses of the contract. In general, these fees in a variable annuity will be charged as a percentage of the average value of the investment. The average M&E of a basic variable annuity contract is between 1-2%. On top of the M&E you also have your investment expenses. Since you’re typically investing in mutual funds you’ll also pay their annual expenses. These can often be between 1-2% as well. So, right out of the gate you could be paying upwards of 4% per year just for opening a variable  annuity!

We aren’t done with fees yet. Next, you have to worry about surrender fees. A surrender fee is a fee applied if you cash in before a set amount of time. In many cases the surrender period will be around seven years. What the annuity may do is charge you 1% for each year you take your money out early. So, if you withdraw the funds in the first year you’d be socked with a 7% penalty. Take it out after 6 years and still get hit with a 1% penalty. After holding the funds for 7 years you’d finally be free to take your money without paying a surrender fee. Surrender fees apply to both fixed and variable annuities.

You think we’re done with fees yet? Hardly. Now, we have to talk about riders. Riders are additional features that you can add to your annuity contract. Common riders can provide some additional guarantees. They might provide additional guaranteed income, protect against losses, increase payouts for inflation, or extend the death benefit. Obviously, these features cost extra. Riders often cost between 10 and 100 basis points (0.10% to 1.0%) per year. So, if you’re in a variable annuity already paying a 1.5% M&E, 1.5% fund expenses, and tack on riders that add 1% you’re paying 4% a year in fees.

Annuities Have Their Place

Annuities seem like a pretty bad deal after looking at all of the fees and restrictions discussed above, but they do have their place. For one, they really can provide guaranteed income for life. They are insurance contracts and once annuitiezed you’re going to get a payment for the rest of your life. For retirees who want this sort of safety they can be an attractive option.

But here’s the problem. Many so-called financial advisors and insurance agents sell annuities to people who still have many years before retirement. So, what happens is they convince someone to put their money into an annuity, either fixed or variable, and make a hard sell by promoting all of the guarantees. It’s one of the few instances in the world of finance where you can get away with offering a guarantee. So, they get someone who is say 50 years old to buy an annuity contract and then they spend the next 10 or 15 years paying these unnecessary fees before finally retiring.

There are very few reasons to invest in an annuity well before you’re thinking about annuitizing it. If it’s a fixed annuity, you’re playing the rate game. You might get a good rate right now, but how will that rate stack up in 5 years? And don’t forget, you have surrender charges to deal with that could prevent you from moving the money into something with a better rate. And if you’re looking at a variable annuity you’re subjecting yourself to high and unnecessary fees that can erode your earnings significantly in the years prior to annuitizing.

If you really do want a source of guaranteed income for life an annuity can do that, but you should consider an immediate annuity. This means you would only buy the annuity contract when you’re ready to start receiving those guaranteed payments immediately. This allows you to invest your money however you want in low-cost funds on your own and then when you need to begin receiving a fixed income from these investments you can immediately turn it into an annuity and make this happen. This way it doesn’t matter what the rate is on a fixed annuity or require you to negotiate high fees and poor investment options in a variable annuity.

Generating Your Own Income for Life

An annuity is just one way to generate income for life, but you can go about it on your own, too. As you approach retirement you’re probably starting to get a little more conservative with your investments. So, you’re investing more in things like bonds, CDs, and money market accounts. Essentially, after you’ve spent your working years accumulating that retirement nest egg you’re trying to preserve as much of that egg as possible while earning enough to at least keep pace with inflation.

Ideally, you will have created a portfolio large enough so that you can simply withdraw the interest generate each month, or at the very least, draw the interest and a small portion of your principal so that you won’t outlive your money. That is often easier said than done because it requires a few things to fall in place. First, you need to save enough during your working years to build up a portfolio large enough to sustain this withdrawal model. Second, you are at the mercy of the economy, interest rates, taxes, and investment performance. With so many unknowns it’s possible for even the best plan to be insufficient once retirement does arrive. But done right, you can create an investment portfolio that generates enough income that can provide you the money you need for the rest of your life.

That being said, annuities can still play an important role. Most of us, retirees included, will have some fixed expenses throughout our life. For some it’s a mortgage, and others it could be medical costs, groceries, or insurance premiums. Because there are some things that we’ll need to spend money on regardless one strategy is to use an annuity to take a portion of your nest egg and use that to generate some fixed income to cover the necessities while using the rest of your portfolio to tap into as needed to pay for the rest. This way you get some guarnteed income each month while still having control over the bulk of your money.

Start Planning For Income Now

Even if you have 30 years until retirement it’s a good idea to begin planning for how you’ll be generating income once you do retire. Sure, we have no idea what the future holds that far off, but begin thinking about your options and how important it is to have a guarnteed source of income. A lot of things will change, but if you’re aware of your options and know what to expect when it comes to generating income for life you can be better prepared to make the best decision with your money.

And finally, if you’re in you’re still a number of years away from retirement and are approached by someone trying to sell you an annuity just turn around. Tell them to give you a call when you’re 65 and actually getting ready to retire. Their sales pitch may sound great with all of the guarntees, but you know better. Annuitizing some of your money might make sense once you do retire, but until then, keep control of your investments and avoid making the insurance companies rich in the meantime.

Author: Jeremy Vohwinkle

My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.

12 comments
Mike   Annuity Rates
Mike Annuity Rates

Everybody wants a continuous cash flow even after retirement. In that sense, annuity is good because it guarantees a continuous cash flow even after retirement. But unfortunately annuity is not as popular s it should. I think the reasons behind this are the complex nature of annuity and the high fees associated with it.

Family Man
Family Man

Some very interesting and informative information. I am not a huge fan of annuities, but you raise some good points. Thanks!

Financial Samurai
Financial Samurai

Not a fan of annuities.

Just save $3 million bucks and live off the 4% interest income of $120,000/yr while living in a no income tax state! Perfect :)

Life is simple guys. Don't make it complicated!

Jeremy
Jeremy

I'm sure I could have planned the article out a little better to highlight some of the pros and cons better. I'm not one to spend weeks in advance outlining an article and usually just write off the cuff so it's obvious I missed some key points in the original post.

I still stand by the position that the so-called safety (I'm talking VAs here, not fixed) you get with many of the riders is money thrown out the window unless the stars align in your favor. If you want to invest in 100% stocks and pay 3-4% each year so that you can sleep at night knowing the worst case scenario is you'll get your principal back, well, you can create a diversified portfolio that can squeeze out fairly consistent moderate gains, which is what you'll end up with investing aggressively while having a large chunk taken out for expenses.

If the stock market averages 10% a year and you're paying 4% in total expenses you're left with a 6% average return for that piece of mind. I'd just argue that you could skip the variable annuity during the accumulation phase construct a conservative portfolio that gives you fairly consistent returns in the 6% ballpark over that same time frame without taking on too much risk and without forking over 4% to an insurance company. Sure, investing in a way that's targeting a consistent rate of return in the 5-6% range is limiting your upside, but it's also providing you with a safety net in that you're not relying entirely on the stock market.

But, different strokes for different folks I guess. Some will like the ease in just dumping their money into a single vehicle and buying the protection for a set fee, and others can accomplish the same thing on their own or with a quality financial planner.

Evolution Of Wealth
Evolution Of Wealth

Jeremy I have to side with Evan here. I appreciate the gesture of writing a not too biased article but in your comments the truth comes out. So why not put your feelings into the article? Why not title the article "Annuities are a horrible ripoff" and run with it? Why pretend?

I wrote a post called "At What Cost?" http://evolutionofwealth.com/2009/09/30/at-what-cost/
The purpose was to ask about the expense of a safety net. It's not about gambling for it to pay off it's about peace of mind and knowing what the worst case scenario is. You limit the upside a bit to give you that safety net under just in case the market let's you down. Isn't it possible it could do it again.

Evan
Evan

Jeremy,

I am happy to have this discussion with you because I think your comments provide a clearer indication how you feel about the product than does your post.

"I’m just saying that most riders on variable annuities are a gamble, just like betting the farm on a few individual stocks is."

But the difference is the purpose of purchasing the rider vs betting on individual stocks. The product is made for someone that is looking for safety.

As far as Fixed Annuity Rates - I just looked some up and you are correct they are much lower than the 5% number I gave, but I found a few there were about double of ING's Account (apparently, it has been a while since I looked at the annuity Market lol). That being said, I think you'd be hardpressed to create a bond fund where you were getting Net 5% with the low risk of a aa1 or thereabouts insurance company. Go CIT bonds lol jk

"Annuities should be used to lock in guaranteed income for life. That’s what they were designed for, and if that’s what you want, they are a great tool. But if you’re looking for a way to beat the market or find some sort of safety during your accumulation years, you’re basically rolling the dice in hopes that somehow what you purchased will pay for all of the added fees you’re assuming for that safety"

I couldn't agree more with the sediment that they should be used to create a steady income stream. That is what they are there for, and I don't think you are going to get a homerun out of them in an up market - but for safety purposes in a down market there is no roll of the dice, if you were to use a guaranteed Income/Minimum benefits rider in a down market. Since no one knows what we will have for the next 30 or so years, I just don't think it is entirely bad to have a little safety.

Jeremy
Jeremy

Evan,

"When those fees are associated, like you said in your comment, but not in the article, with creating further safety of principal (and possible growth) for a price, i.e. the cost of the rider – why would you then tell someone to invest in a few individual stocks?"

I'm just saying that most riders on variable annuities are a gamble, just like betting the farm on a few individual stocks is. If you buy the rider and your portfolio doesn't go up enough to cover the cost of the rider over that time, you wasted money. If the market goes up (which most people hope it does) your rider is likely useless again and wasted money. So you're basically taking a gamble in that the market goes down enough that you can utilize your rider and come out ahead. With long-term market trends, that's a losing bet and it all comes down to your luck of timing.

"Partially correct, if you have an annuity with guaranteed growth of NET 5% (think fixed annuities) and CSDCs (surrender charges) for 7 years and you don’t have any intention of invading for 7 years, would you rather see that money in an ING account with 1.3% Gross?"

Come on now, let's not get carried away. Let's not compare a 5% fixed annuity with an ING savings account. First of all, I'd love to see a fixed annuity right now paying 5% net for a full 7 years. I haven't paid much attention to the annuity market in recent years but even back when you could get CDs for 5% APY it was nearly impossible to find a fixed annuity that would pay out that high for more than a year or two.

Second, if you're going to compare something like that there are all sorts of alternatives that can net you close to 5% and still be virtually guaranteed. By the time you look at the bond universe and put together a portfolio that would do quite well.

"It should also be noted that while those fees absolutely hurt, the growth is tax deferred – so those fees are somewhat mitigated when comparing net returns in a mutual fund."

I'm ignoring tax-deferral because what happens is most people end up rolling their retirement nest egg which happens to be n a 401k or IRA into an annuity thanks to the salesman pushing the product. I saw it happen every day at my old job. Most people weren't sitting on a pile of taxable investments and then decide to roll it into an annuity. Of course the tax deferral is an important consideration IF you're comparing after-tax growth vs. tax deferred.

And finally, I'm not saying annuities are bad at all. I specifically mention how they are a great way to lock in money and receive a regular payment for life. That is exactly what annuities are for and have a number of uses for this. My problem is when people try to mix long-term investing with annuities. All of the riders and features and other bells and whistles are just sales gimmicks. Yes, they can and do pay off at times, but for the majority of people they just end up costing money that otherwise could have been avoided.

Annuities should be used to lock in guaranteed income for life. That's what they were designed for, and if that's what you want, they are a great tool. But if you're looking for a way to beat the market or find some sort of safety during your accumulation years, you're basically rolling the dice in hopes that somehow what you purchased will pay for all of the added fees you're assuming for that safety. It might work out, but it might not. So for me, I'd rather construct a portfolio on my own that minimizes risk and decide on my terms down the road whether or not to convert that into guaranteed income for life.

Evan
Evan

Jeremey,

I am not a monster fan of Annuities, I just think it is easier for most PF Bloggers to repeat the oft heard, "Say No to Annuities too many fees."

"Riders are expensive. Period. If you’re going to take the gamble and waste potentially tens of thousands of dollars on added expenses for choosing an annuity and then a rider on top of that you might as well bet your entire retirement on a few individual stocks"

When those fees are associated, like you said in your comment, but not in the article, with creating further safety of principal (and possible growth) for a price, i.e. the cost of the rider - why would you then tell someone to invest in a few individual stocks?

"If you don’t get lucky enough to even use your guaranteed income/principal rider you’ve just thrown money away."

Partially correct, if you have an annuity with guaranteed growth of NET 5% (think fixed annuities) and CSDCs (surrender charges) for 7 years and you don't have any intention of invading for 7 years, would you rather see that money in an ING account with 1.3% Gross?

It should also be noted that while those fees absolutely hurt, the growth is tax deferred - so those fees are somewhat mitigated when comparing net returns in a mutual fund.

Again, I am not a huge fan of annuities, but they absolutely have their place in some people's world. I just think your post is below your usual level...basically providing an argument that Annuities could be good for some people (safety) and then just revert back to the garbage...but they are expensive.

Jeremy
Jeremy

Riders are expensive. Period. If you're going to take the gamble and waste potentially tens of thousands of dollars on added expenses for choosing an annuity and then a rider on top of that you might as well bet your entire retirement on a few individual stocks.

For high watermark and similar riders to work you're essentially betting on the fact that you buy your annuity at a low point, in a few years it rises, and then just before you are ready to retire the market tanks. If that doesn't happen you've likely just wasted a ton of money over the years on useless expenses when you could have invested on your own and then purchased an immediate annuity once you're in retirement.

Furthermore, many of those types of riders will additionally dictate how you must withdraw the money in the event you choose to use the benefit of the rider. While you might be able to lock in a higher amount if the market falls right when you're about to retire you might not have the flexibility of payout.

If you don't get lucky enough to even use your guaranteed income/principal rider you've just thrown money away. For example, if you buy a $200,000 annuity contract and hold it for 10 years and your portfolio doesn't even realize any gain, after you factor in say a 1.5% M&E, fund expenses, and maybe another 1% in riders you've spent nearly $70,000 in fees over that 10 year period. You could have invested this money on your own and realized a 30% loss over that period and still have roughly the same net result.

That's why these products are offered by insurance companies. They make money by assessing risk and then charging an appropriate premium for the protection. They make money because more often than not they won't have to pay out because of life expectancy, the market doing good in the long run, or the fact that most people never annuitize to begin with.

Riders can be a benefit, but it's a big IF. IF the market happens to go down significantly right when you plan on taking the money, yes, the gains you were able to lock in may offset all the costs and you MIGHT come out ahead. But the odds are not in your favor and you're better off accumulating assets on your own terms and only using an annuity once you decide you want to lock in that income for life.

oscar trejo
oscar trejo

i'm 56 yrs old, i have 20 yrs more on my mortgage.
how do i save, so i can have income for life?

Evolution Of Wealth
Evolution Of Wealth

Evan brings up an interesting point. In your last paragraph you bring up the point of planning ahead for income. Wouldn't it them make sense to weigh the value of annuity riders especially if you are within 10 years or so of retirement? Then you tell people not to look at annuities until 65?

Evan
Evan

I do not currently own any annuities, but it seems that you are missing a huge benefit associated with them beyond the guaranteed income for life.

Many products despite their fees, have riders and guarantees which essentially ratchet up your gains in what is usually referred to as a phantom account. So even if your mutual fund non-qualified investment account is down 30% a la 2008 - your VA account may have limited your downside risk and while your real cash account is down 30%, your phantom account (the one which will be used to annuitize) could be even or actually up for the year.

Again, this plays towards someone safety concerns, however, this could be a HUGE upside in a down market.