February 6, 2022
Sid Roy
This month we talked about a topic that mystified me personally for a while – annuities. This session was super informative and cleared up many beginner questions. This article summarizes the discussion we had. Annuities are a broad and deep topic so we will cover it in multiple articles.
So, what are annuities? The simplest way to understand annuities is to think of a concept most of us are familiar with – the house mortgage. In taking out a loan to finance the purchase of a home, we agree to pay the bank or financial institution – the principal and an agreed upon interest over a period, say 30 years or so. With annuities, the roles are reversed in some sense. In this case, you are going to pay (akin to giving a loan) a financial institution some money and it in exchange will make recurring payments to you over your lifetime. The promise of an annuity is to reduce financial uncertainty in your later years with secure lifelong recurring payments.
Another common way of looking at annuity is to think of it as a private pension. In a typical government pension, an employee works for a certain number of years. In addition to the salary, the employee receives a pension to guarantee financial security for the rest of her life. This pension is a form of compensation except that it is deferred till retirement. Typically, the employee and the employer both make some contributions during the period of employment and in return the employee receives a guaranteed income post retirement. In most cases, the employee can opt for a lumpsum payment at retirement instead of lifelong income.
An annuity is a form of a private pension where one reaches a similar contract with a private financial organization. The individual can contribute either in lumpsum, or in periodic payments. After a selected time-window, the accumulated fund can be annuitized to distribute recurring periodic payments over the lifetime. The keyword is “lifelong” – the payment continues for as long as the investor lives.
Hopefully, the basic idea of annuity and its role in a portfolio is also becoming clearer. The purpose of the annuity is to create a fixed income guarantee during the years when you stop earning. It provides financial security that no matter what happens, you are always assured of a specific sum of money as long as you live. Many of us worry about longevity risk – the risk of running out of money if we live too long. Annuities are a form of insurance against that risk. Like many insurance products, risk-pooling is in play here. Folks who live longer benefit from the contributions of the annuity receipients who had a shorted lifespan.
Americans have the benefit of Social Security payments as a source of retirement income. The Social Security checks are annuity payments that’s calculated based on how much the beneficiary contributed to the Social Security. Like private annuity products, the Social Security payment amount goes up if the recipient chooses to defer collecting the checks. Folks who worry about longevity risk postpones taking distributions to maximize payments. To sum it up, the purpose of the annuity in your portfolio is to reduce the longevity risk with assured payments for as long as you live.
Let us understand a bit more how it works. Every annuity has an accumulation period and a collection period. During the accumulation period, you make contributions into the account. The money is put to work in appropriate investments. During the collection period, which is typically when you are retired, you get recurring payments.
Annuities can have different options across each of these aspects – the premium payment, the distribution, and the investment type. Let’s look at each of these aspects independently.
Annuity premium can be paid over a period in small amounts. Social Security and Workplace Pension plans resemble periodic premium annuities, where the contribution happens over time. Insurance companies also offer single-premium annuities where the entire premium can be paid up in a lumpsum at the beginning of the contract. The premium is invested and accrues interest until the distribution phase starts. In case of Immediate Annuities, the distribution starts immediately. In case of Deferred Annuities, the distribution starts at a future date. Deferred annuities that start at a much later age are also called Longevity annuity.
The third aspect of the annuity relates to how the funds are invested. The simplest form is a Fixed Annuity where the amount that you get is fixed every month. To assure a guaranteed payment, the insurer would invest the amount in stable investments. Naturally, the payout from such annuities tends to be smaller, and doesn’t keep up with inflation.
On the other hand, Variable Annuities have the fund invested in riskier assets that tend to be volatile. Though such investments are expected to grow over a long time, there is no assured return from them in a given period. Hence the payout of a given period is also variable.
There is also a third kind – which is hybrid – there is a fixed payout component and a variable component. The reasons for these variations are not hard to see. The fixed annuity suffers from the effects of inflation over long horizons. If you had started receiving an annuity of $10,000 dollars in the year 2000, the equivalent amount that you really need in 2022 is around $16,000. This might be seen by some as defeating the very financial security reason for annuity purchase unless you purchase a ladder of deferred annuities so that your payout increases over time as payments commence from the additional annuities.
The variable annuity aims to redress with variable returns based on the performance of the underlying assets. So, if the underlying assets did well during that time, then you might be getting $16,000 or more in 2022 instead of $10,000. But the flip side is true as well. If the performance is poor, you might end up getting less than $10,000 every month. So, the variable annuity comes with its own risk.
Finally, the hybrid aims to strike a balance between the two with a fixed and variable component of return. Not that it is a panacea. One must carefully look at the details to make sure it is a good fit for one’s needs.
How do you know that an annuity is right or not for you? The answer depends on where you stand with respect to having an assured source of sustainable income for your likely lifetime. Consider your potential investments at retirement. How susceptible are you to market downturns? How long can you sustain a downturn without a catastrophic change in your lifestyle? Take a look at the recent downturns of 2020, 2008 and 2000. If any of this happened during your retirement, would you be able to sustain it? How much Social Security do you expect to get? For people, who can sustain their lifestyle through Social Security itself, there may be a lesser need to consider annuity compared to others who may not be in the same position.
There is a lot more to cover on annuities. We learned today what an annuity is – it is a financial product that generates fixed income over one’s lifetime post retirement. We learned that – it is meant to reduce longevity risk by security recurring payments post retirement period as long as you live – in other words your private pension. We also learned about the basic types of annuities that are available and some considerations before you opt for annuities.
That is all for today and we will see you in the next session.