Almost anybody can tell you what life insurance is. The concept is pretty simple – you are paying an insurance company a premium and if you die while the insurance contract is in force, the insurance company has to pay the agreed upon benefit.
An annuity is really the opposite. For an annuity, you pay the insurance company a premium and they pay you until you die. As with life insurance contracts, there are all kinds of variations – from death benefits to inflation protection and about anything in between. You can customize an annuity to fit almost any request. Research shows, however, that the annuity that provides the best value is also the most straightforward, the single premium annuity. This type of annuity can be either immediate – in which the annuitant pays the premium and the income stream begins immediately, or a deferred annuity in which the annuitant pays a premium and then 5, 10, or 20 years later begins receiving income.
If you are breathing and have at least one hand to sign your name with, you have probably had somebody try to sell you an annuity. The pitch sounds great – you get a guaranteed income stream that might be as high as 8% of your investment every year. If getting 8% of that investment back each year is enough to cover your annual expenses (with a little left over to be able to compensate for future inflation), you might be wondering why you shouldn't do the annuity. Well, you would be in good company as many economists and financial researchers have asked the same question. Economists call it the annuity puzzle – if annuities are so great, why aren't people buying them? For researchers, the annuity represents an interesting option in that it removes most of an individual's longevity risk (the risk of outliving your money), while providing a relatively high level of income. In a 1965 paper
, Menahem Yaari, former Yale professor and economist, wrote that essentially everybody should annuitize all their assets at retirement.
You might be surprised to hear, then, that I have no intention of annuitizing my own assets at retirement. In many of these research papers, the benchmark investment portfolio was comprised of US Treasuries or TIPs or simply given a real rate of return that corresponded with such investments at the time of the study. Why is that important? Because very few people are so conservative that they are unwilling to take on any investment risk. While the almost risk-free profile of Treasuries is a fitting comparison to an annuity, the result doesn't tell us much. If you were planning on using treasuries to fund your retirement, you should use an annuity.
But what about the rest of us? I plan on having a diversified portfolio with at least 50% in stocks during retirement. That portfolio's real return is certainly not the same as Treasuries, but is appropriate for an investor who has a 20+ year time horizon. At least, I hope to live at least 20 years in retirement (and if I don't live that long, then I REALLY don't want an annuity). When you compare this type of portfolio with the annuitized plan, you come up with a much different result. Now, the investments not only generally meet the required annual expenses, but also leave a legacy to pass on to heirs. Research
from Dr. Moshe Arye Milevsky, finance professor at York University, found that when compared to a portfolio with investment risk, retirees have almost no reason to annuitize before 75-80 years old. Even after 80, the retiree may not want to annuitize but at least then the income stream is high enough to justify purchasing an annuity.
For the acutely risk averse retiree, an annuity can provide secure retirement income and reduce longevity risk. That security comes at the cost of flexibility and the risk of dying prematurely and essentially throwing away your investment. Those who are willing to take on some investment risk, however, might have far more satisfactory outcomes by simply sticking to a sound investment plan.