But always check the fine print
Higher guaranteed income: What's not to like?
Market turmoil has created a remarkable opportunity in recent weeks for retirees and those seeking secure, stable income for life.
Annuities can provide retirees with a guaranteed income for the rest of their life. Immediate or income annuities, which are insurance contracts that convert a lump sum into a stream of income, have just seen payout rates rocket to their highest levels since around the time of the global financial crisis nearly 20 years ago.
Those annual payout rates have risen as much as half a percentage point in just a few weeks, following the late summer selloff in the bond market. Insurance companies that sell these annuities use Treasury and investment-grade corporate bonds to finance them. As bond markets fell and long-term interest rates rose, insurance companies raised payout rates.
As a result of the market moves, a 65-year-old man can earn a guaranteed income for life of 8.4% on an investment, and a 65-year-old woman could see 8%. In other words, if you invested $100,000 in an immediate or income annuity right now, as a man you'd earn $8,400 a year and as a woman you'd earn $8,000 until you died.
If you are worried about inflation - and who isn't right now? - you can buy an annuity that raises those payouts by, say, 3% every year. In exchange, your starting payout rates at 65 would be lower: 6.4% if you're a man or 6.1% if you're a woman.
(The payout rates for women are lower because they live longer, on average. Actuarially, they work out to be the same.)
Guaranteed income
I'm certainly not running an advertorial for insurance companies and annuities, but there is no doubt that mathematically, they provide the highest possible guaranteed lifetime income out of a lump sum. That's because they work as a form of life insurance, and those people who buy an annuity and die young effectively subsidize those who live to be very old.
Financial planners often talk about a 4% or 4.5% rule, which means that when you retire, you can withdraw 4% of your assets in your first year, raise those withdrawal amounts each year in line with inflation, and have an excellent chance of making your money last until you die.
Those who buy an annuity give up liquidity: The money is tied up, effectively forever, in the insurance contract. And they are vulnerable to 1970s-style inflation, because whatever annual increase you lock in when you buy the contract is all you're going to get.
I'd argue that both of these downsides look worse than they are. You effectively give up a lot of liquidity if you keep your investments in stocks and bonds and try to follow the 4% rule, because you can't use the money for a big-ticket expense and still allow it to compound to finance your 4% rule. And while you might think a stock-and-bond portfolio offers better protection against a big rise in inflation, that's a shaky argument.
The inflation of the 1970s proved a disaster for stocks and bonds. There's every reason to think a regular investment portfolio would suffer badly from a rerun of that scenario. Furthermore, annuity payout rates start so far above 4% or 4.5% that you have plenty of cushion before they turn into a comparatively worse deal.
Using annuities the right way
In any event, retirees are rarely advised to put all of their money into annuities.
"Higher payout rates make income annuities worth a fresh look, but only for money a client needs to turn into a paycheck, not money meant to grow," says Jeff Judge, a financial planner with Chesapeake Financial Planners in Forest Hill, Md. "I use annuities to cover essential bills, not to chase returns."
Juan Hernandez-Ariano, a financial planner with WealthCreate in Houston, Texas, says annuities like this can either be a great retirement tool or a very bad decision, depending on the individual's own circumstances. Current payout rates make them very attractive, he says, but adds: "I wouldn't use one for someone who'd have to put most of their savings in to make the numbers work, because there's no getting that money back for something like a hurricane deductible."
And Josh Norris, a financial planner with LeFleur Financial in Jackson, Miss., says the jump in payout rates is a bit of a red herring. "Whatever payout the annuity companies offer is based largely on what they can make on your money, and that's the return you forgo to buy their annuity."
He's right, but with one caveat. Insurance companies tend to buy bonds first and then use them to finance their new annuities, with the result that annuity payout rates tend to reflect the interest rates in the bond market from a few weeks ago. As a result, the juicy annuity rates on offer today reflect the historic interest rates seen on bonds in late September and early this month. Those bond rates have come down in the last few weeks, and if that continues, annuity rates can be expected to follow suit.
"Payout rates typically track to long-term yields with a lag," explains Keith Golembiewski, head of annuities research at the life-insurance trade association LIMRA. Those lags vary between insurance companies but typically are between two and four weeks, he adds.
What to watch for
Consumers should always look carefully at the terms and conditions of an annuity before assuming it's a good deal.
Hernandez-Ariano, a qualified insurance salesman, warns that those selling insurance are not held to the same high standards of fiduciary responsibility as financial planners. So always check what you are buying and who you are buying it from, and ask about their sales commissions.
A well-known place to shop for annuities is at immediateannuities.com, which is run by Hersh Stern, the company that published Annuity Shopper for decades.
Immediate, lifetime or guaranteed annuities should not be confused with various other products that are called annuities, such as indexed annuities, which are typically tax-advantaged savings and investment vehicles. The problems with so many of those include high fees and lock-in periods with hefty withdrawal penalties.
Beating inflation
If you really want inflation protection, nothing will beat inflation-protected Treasury bonds, known as TIPS. If I sound like a broken record on TIPS - and on guaranteed-income annuities, for that matter - there are good reasons for it. Both offer compelling tools for squaring the circle that many people face when they retire: squeezing out the maximum material standard of living for the rest of their life.
TIPS bonds are, by historic measures, somewhere between a good value and a ridiculous bargain, depending on whom you ask. Long-term TIPS yields are now between 2.5% and 3% a year plus the official inflation rate, whatever that turns out to be. For most of the last 20 years, TIPS were ridiculously overpriced, as part of the great zero-interest-rate bond bubble, and offered paltry yields.
Bonds are like seesaws: When the price rises, the yield or interest rate falls, and vice versa.
At several points during the last 20 years, TIPS sometimes offered negative real yields, meaning you were guaranteed to lose purchasing power over the life of the bond. I never understood why anyone would bet on a horse after it had lost a race. Various financial planners tried to explain it to me, and doubtless they had good reasons, but it seemed an unappealing option. And so it proved to be.
Today, on the other hand, those inflation-adjusted or "real" yields are at generational highs.
The main risk, as with any Treasury bonds, is that the insane U.S. budget deficits could lead to a budget crisis. On the other hand, anyone buying TIPS, even very long-term TIPS, has two advantages. First, a U.S. debt crisis would collapse the entire financial world, so even Congress wouldn't let it happen. (Also, everything else would fall, not just Treasury bonds.) Second, the most obvious, politically cowardly way out of our debt mess is through inflation - which would be OK for TIPS, if not for regular bonds.
But while TIPS might protect you against inflation, they won't protect you against longevity. That's why people are often advised to buy annuities.
-Brett Arends
Comments