Friday, March 31, 2017

My Appreciation of Annuities Has Grown

I believe I've told this story before, but a friend once brought his wife, whom I'd never met, to my home to talk about retirement planning. As I tried to introduce myself, she interrupted me to say, “If you recommend a life annuity I will get up and walk out.”

Nice to meet you, too!

I have also received emails from readers saying they would never consider investing their hard-earned retirement money in the stock market.

And so it goes. People have strong opinions about both. Because I believe that the most important requirement for a good retirement plan is that the clients can sleep at night, I rarely try very hard to convince them to change their beliefs, though I do try to present fair assessments of both alternatives.

If you firmly believe that annuities or the stock market are not for you, you are probably right.

I have always believed that life annuities can play a critical role in many retirement plans but my appreciation for them has increased over the years. For anyone who is on the fence about life annuities, I'd like to share some different perspectives that may help you decide.

A life annuity is a contract typically sold by an insurance company to an “annuitant” (often a retiree) guaranteeing periodic payments for as long as the annuitant lives. In retirement planning, we use annuities to mitigate longevity risk, the risk of outliving our retirement savings.

The payout for a single male aged 65 today is about $560 per month, or $6,737 annually for a $100,000 annuity. That's about 6.7% annually. That is not equivalent to a 6.7% investment return because part of this payout is a non-taxed return of your own capital. The equivalent investment return will depend on how long you live. It will begin with a negative return and, should you live long enough, it will eventually exceed the payout rate. [1]

The insurance company invests the premiums you pay in bonds. It also uses premiums paid by annuitants who don't live a long time to pay annuitants who do live a long time using what are referred to as “mortality credits.” The payouts you receive come from bond interest, from a partial return of your own capital and, if you live longer than average, from mortality credits.

Perhaps the greatest objection to life annuities, and the one my wife's friend found unacceptable, is the fact that a life annuity typically has no value after the annuitant dies. True, some annuities offer riders that guarantee income for a number of years (period certain) or guarantee repayment of some principal to beneficiaries, but these riders are expensive and may not be worth the cost.

The fear is that the retiree will buy an annuity and die before enough payments have been received to cover the annuity's cost. This is what had happened to my friend's sister-in-law and why the return on investment for an annuity starts out negative.

This is the same “break-even” analysis that many use to justify claiming Social Security benefits as soon as possible and the problems are similar. Both Social Security retirement benefits and life annuities are insurance – not investments – that mitigate the risk of living a long, expensive retirement. If the annuitant doesn't live a long life, then he or she would clearly have been better off not purchasing the annuity, but that isn't something we can predict.

That insurance has value whether or not we make a claim. The retiree who purchases an annuity at age 65 but only lives to age 70 mitigates the risk of a long life even though he didn't happen to live to an old age. People who purchase car insurance but don't have an accident rarely argue that their premiums were wasted, nor do homeowners who buy insurance but don't have a fire of flood claim. Many retirees considering annuities apparently don't see longevity insurance in the same way as they view other policies but purchasing life annuities and delaying Social Security benefits provide a very real transfer-of-risk insurance benefit.

For every story of a relative who purchased a life annuity and didn't live long after the purchase there is a story of someone who benefited from mortality credits. You may do better or worse when purchasing an annuity, but in either case you were insured against a long, expensive retirement.

“Some prominent figures who are noted for their use of annuities include: Benjamin Franklin assisting the cities of Boston and Philadelphia; Babe Ruth avoiding losses during the great depression, and O. J. Simpson protecting his income from lawsuits and creditors. Ben Bernanke in 2006 disclosed that his major financial assets are two annuities.” —Wikipedia [2]

Liquidity is another concern for the purchaser of a life annuity. The annuitant takes a large sum of cash that could easily be spent and purchases a life annuity whose value can only be spent as periodic payments. Let's assume a retiree decides to spend $100,000 of cash on a life annuity that pays $6,000 a year. She no longer has access to the $100,000 to cover large bills; she only has $6,000 per year in liquid assets, albeit for the rest of her life.

One alternative to purchasing a life annuity is to “self-annuitize” with a “sustainable withdrawal rate.” SWR strategies work by over-saving. The funds that must be kept on hand to reduce the probability of depleting one's savings aren't really available for spending, either. They are needed to generate future income and to ride out periods of poor market returns. Furthermore, it has been shown that this strategy is economically inefficient (i.e, expensive).[3]

Liquidity is a valid concern and retirees need to consider their remaining liquidity should they purchase an annuity. This consideration, however, should take into account the true liquidity of alternative strategies. Those savings may not be as liquid as you thought.

For households that will fund retirement with a mixture of annuities and investments annuities will enable a more aggressive investment portfolio. A household that has a significant floor of Social Security benefits and life annuities can absorb market losses more confidently knowing that its base income is secure.

Different Perspectives on Life Annuities
  • The insurance has value even if we don't “make a claim” (live to an old age)
  • Annuity alternatives may not have the liquidity they appear to have
  • Annuities give the retiree more confidence to invest a market portfolio more aggressively
  • Some retirees lack interest in investing 
Lastly, I have come to appreciate life annuities more because my wife, despite her MBA, has little interest in investments. Should she survive me, she will probably be far happier with a secure base of income and less need to worry about investment results.

She doesn't actually feel that way, though. She's not that keen on handing over part of our savings to insurance companies for annuities. Still, she hasn't threatened to walk out if I mention them.


David Blanchett, Michael Finke and Wade Pfau published a paper entitled “Planning for a More Expensive Retirement[4] in the March issue of Journal of Financial Planning. The paper contains a wealth of data explaining why funding retirement is quite expensive today. The following chart from that paper shows that the cost of buying one dollar of real annuity income at age 65 has more than doubled since 1982.

The cost of a dollar of real annuity income increased as the result of two trends: a long-term decline in interest rates and an increase in life expectancy, both of which tend to increase the cost (lower the payout) of annuities. While interest rates are historically low and may revert to the mean going forward, life expectancies should continue to increase, though perhaps at a slower rate than over the past three decades. In other words, while two factors lowered annuity payouts only one is likely to reverse.


[1] Payout Rates and Returns on Income Annuities, Wade Pfau.

[2] Annuity (American), History, Wikipedia.

[3] The 4% Rule—At What Price?, Jason S. Scott, William F. Sharpe, and John G. Watson, April 2008.

[4] Planning for a More Expensive Retirement, Blanchett, Finke, Pfau, 2017.


  1. Dirk, great balanced view on the pro's and con's of annuities. We're seriously considering one as longevity insurance, and your overview is most helpful! (I may even include it on a future blog post I'm planning about annutities, trust that's ok with you?)

  2. As an owner of immediate annuities, I second the balanced, largely positive analysis you've put together. Annuities can be a real help for us "unwealthy," who are purportedly the target audience for this blog.
    After my husband's total disability, I bought one in 2010 through Vanguard with about a third of our savings; note I'm talking about the plain vanilla, low-commission product with no added bells and whistles, NOT high-cost, sales-pitched variable kinds.
    After my husband passed away, I bought another in 2014, same thing except from a different insurer, again through Vanguard. Between these two annuities and SS, now all my living costs are covered, and I still have a comfortable portfolio balance to provide for inflation adjustments, emergencies, etc.
    Yes! it was hard to see the $100,000 leave the portfolio, but yes indeed! it is so gratifying to have that income arrive reliably month after month. No worries about income.
    You've performed a valuable service, Dirk, for other "unwealthies" like me who may now at least consider some type of SPIA or DIA.

    1. Thanks for sharing. "Largely positive" is about the highest level of approval that I will give any investment or product. Every one of them has pros and cons and none is perfect for every retirement situation. Annuities, investment portfolios, reverse mortgages, and LTC insurance, for example, all have flaws but in the right situation their benefits outweigh their shortcomings.

      Thanks for writing!

  3. I think some of this discussion may miss the critical point of annuities, so let me elaborate.

    Annuities are intended to insure against longevity risk, the risk of outliving our retirement savings. Comparing their rate of return to the return on bonds or equities is to a large extent comparing apples to oranges. One insures lifetime income while the other does not.

    Milevsky compares returns in the mentioned research but as a means to determine the best time(s) to buy an annuity *assuming one has decided to purchase one*. That is inherently different than using the rate of return to decide whether to purchase an annuity or to buy bonds. Whether to purchase annuities should be based on broader criteria.

    Can a retiree essentially guarantee a lifetime of income with a ladder of Treasury bonds? Probably. Of course the ladder has to stop somewhere (a commenter here proposed age 100) but an annuity has no “stopping age.” Still, very few of us will live past 100 so the risk is relatively low but non-zero.

    Can a retiree safely fund a long retirement entirely with long bonds and enjoy their higher returns? The answer is no. Long bonds are volatile and haven't historically compensated for their volatility. Unless you're an insurance company, long bonds are probably not a good investment. A bond ladder for this purpose needs to match the duration of liabilities, so years in the near future should be funded by short bonds, intermediate term liabilities by intermediate bonds, etc.

    A big problem with a long bond ladder is that the retiree will be tying up a lot of capital to fund years that she might not survive to see. One financial planner refers to these as “fettered assets” because they appear to be liquid but we can't really spend them because we may need them if we live long enough. A retiree who funds 35 years of retirement but lives only ten will have tied up a lot of capital she will never need.

    Love them or hate them, annuities are the most economically-efficient way to pay for an unpredictable lifespan which is why nearly all economists prefer them. For retirees who are intent on leaving the maximum legacy, the unused portion of the long bond ladder could be left to heirs, though if interest rates increase their value might be significantly lower than expected and heirs may not want to hold them to maturity. Wade Pfau's research has shown that using annuities can actually increase a legacy because we free up other capital to invest more aggressively.

    Still, it boils down to what helps you sleep at night and, as I said, if you don't think annuities or the stock market are right for you then you're probably right. The decision, however, shouldn't be based on whether or not you think you can earn more from bonds than annuities. An annuity returns bond interest and mortality credits while a bond ladder returns only interest.

  4. great post Dirk. Came across your blog not too long ago and have really enjoyed it. Thank you for all the great work.

    Curious on your thoughts on adding inflation adjustments to immediate annuities, especially given the research you've touched on regarding declining real spending throughout retirement?

    1. This comment has been removed by the author.

    2. Great question and I think there are a number of considerations at play.

      I have read analyses that show that insurers may overcharge for inflation protection and perhaps they do. But, I analyzed this once using historical inflation data and found that annuitants are nearly always better off with inflation protection if they live longer than their average life expectancy. Said differently, although annuitants would get an even better deal with fairly-priced inflation protection, they're still better off with expensive protection if they live a long time. And the risk of living a long time is why we buy annuities.

      I think we can compare this to Long-term Care insurance in that it is expensive but if you need it you need it and won't complain about the cost. As Joe Tomlinson once told me, "Despite its flaws, LTCi is probably a better idea than no LTCi." I feel much the same way about inflation-protected immediate annuities.

      Regarding declining spending in retirement, studies by Blanchett and Banerjee and others show that expenses typically do decline with age but not reliably so. Undersavers are likely to see expenses decline and oversavers are likely to spend more as retirement progresses, according to these studies. Retirees who live to around 100 may even see spending return to early retirement levels.

      I like to think of this spending decline as "typical but not guaranteed." Still, in many cases the spending decline would offset the loss of purchasing power.

      My recent post on an optimal annuitization strategy based on research by Milevsky and Young suggests purchasing annuities in smaller chunks as retirement progresses. This should also reduce inflation risk since newer annuities would have shorter exposure than an annuity purchased at the beginning of retirement.

      My current thinking is that the inflation-protection decision should be based on the retiree's safety margin of wealth. If a retiree has significant wealth in addition to annuity income then he or she may be able to easily compensate for loss of purchasing power with other assets. Retirees who are more dependent on the annuity income should purchase the inflation protection.

      Great question. Thanks!

  5. Great post. I have a unique circumstance I'd like to get your opinion on.

    Due to health issues I retired early (might work again, but not at the moment). I am 48.

    We have some income from a business loan to our sons. This to buy condos renting to students in a college town. (not guaranteed, riskier than an annuity, but we know they will do all they can to pay us)

    My wife although not earning a high income is working and we bought a 5 year annuity just to bridge the gap a bit as we were making these moves.

    What is left over is basically invested in balanced funds at 60/40, but we do have some cash.

    The left over amount by itself could almost produce enough income at the 4% SWR for us to make it if everything above failed, but we both know 4% is not really a true SWR depending on SOR risk etc..

    I have thought about taking our cash (most of it) and using it to buy a 10-12 year SPIA to get us to 60 years old (so we'd be close to SS-normal retirement), but also give our leftover 40/60 port time to grow without having to take out of it, or at worst maybe 1-2% if we get into a bind, but the goal is to take none.

    The return on this would only be about 2% at best with current rates. I know we'd do better not doing this, but also knowing we'd have at least some guaranteed income is nice as well.

    Thoughts or ideas?

    1. Thanks for the compliment. Glad you enjoyed the post. Please email me at and I'll be happy to continue the conversation.