7 Reasons Not to Buy an Annuity

Annuity purchases soared the last couple of years, yet only a small percentage of retirees and near-retirees own or consider annuities. That goes against the advice of many economists and actuaries, who say that most people should include annuities in their retirement portfolios.

Some financial advisors and media personalities say annuities never should be purchased. They cite high fees, complicated terms and misleading sales pitches. Those are reasonable arguments regarding variable annuities and some fixed indexed annuities.

The annuities retirees and near-retirees should consider are the plain vanilla, low-fee, traditional contracts, single premium immediate annuities (SPIAs) and deferred income annuities (DIAs). DIAs also are called longevity annuities.

In a SPIA, you make a deposit with an insurer, and the insurer promises to begin paying you a fixed amount of income regularly for the rest of your life, no matter how long you live. You decide when the payments begin, within 12 months after the contract is signed.

A DIA is similar. The difference is the DIA’s income payments begin on a date in the future you select. Usually, DIA payments begin no sooner than two years after the contract was signed and no more than 45 years later (though payments usually must begin by age 80 or 85).

In either the SPIA or DIA you’re guaranteed to receive the income for life, no matter how long you live. There are no additional fees or expenses. All costs and other factors are considered when the insurer determines how much income it will guarantee to pay.

Variable annuities (VAs) and fixed indexed annuities (FIAs), on the other hand, often have several types of fees and expenses that can add up. The income or returns you receive from VAs and FIAs can be uncertain and dependent on a number of factors. You can add riders to them that provide guaranteed lifetime income. But the riders cost additional fees, and the amount of lifetime income can vary based on several factors.

You already have an annuity that pays guaranteed lifetime income, and its payments are adjusted for inflation. It’s your Social Security benefit. The question to answer is whether you should have one or more additional sources of guaranteed lifetime income.

A frequently given reason not to buy annuities is the fear of losing money to the insurer by not living to at least life expectancy.

Most people greatly overestimate the probability of this happening, because they underestimate average life expectancy for their age group.

In addition, it’s important to realize that half the people in an age cohort will live longer than the average life expectancy, and a significant percentage of them will live much longer.

Also, if you’re healthy at age 65, your probability of living beyond average life expectancy is higher. Life expectancy also is greater for those with higher incomes or net worth. In my book, “Where’s My Money: Secrets to Getting the Most out of Your Social Security” (Regnery Capital 2020), I discuss in more detail the misunderstandings many people have about life expectancy.

The bottom line is that many people believe their life expectancy is much lower than it is.

Of course, if you’re in poor health or have other solid reasons to suspect you won’t live until at least average life expectancy, a SPIA or DIA probably isn’t a good use of your money.

It’s a fallacy that the insurance company wins if you don’t live to life expectancy. The insurer assumes half its annuity purchases won’t live to life expectancy and will use the deposits of the early expirers to promise higher incomes to the rest of the group. The higher payments are called mortality gains for those who live beyond average life expectancy.

SPIAs and DIAs shouldn’t be viewed as investments in which you try to beat the market or an insurance company.

Annuities are contracts in which you transfer risks to the insurance company. You transfer the risk that you’ll live well beyond life expectancy. You also transfer the risk of low future investment returns. Annuities, plus Social Security, guarantee you’ll overcome the greatest fear of retirees and pre-retirees: running out of money in retirement.

A related concern is that a SPIA or DIA leaves nothing for heirs. That’s mostly true. If leaving a legacy is one of your goals, you’ll need additional assets or life insurance to do that. That’s one reason almost no one should have all or most of their net worth in annuities.

You can add a provision to a SPIA or DIA that pays some or all of your initial deposit to beneficiaries if you don’t live to at least life expectancy. But that reduces the regular guaranteed income paid to you.

Another reason not to buy annuities is people believe they’ll generate more income from investing than the annuity would pay. The Federal Reserve has supported investment returns since 2009, and that has distorted views of investment risks and returns.

Most people tend to overestimate the likely returns from investments and underestimate the amount an annuity will pay. Also, you should consider that annuity payments are guaranteed while investment returns are not.

Interest rates have been low for years, and that’s discouraged many potential annuity buyers. They say they’ll wait for higher interest rates. People have told me that since the 10-year treasury bond yield dipped below 7% in the late 1990s. They’re still waiting for those higher yields to return.

But someone who’s been holding money while waiting to buy annuities at higher rates should be investing that money conservatively to protect the principal. If so, it’s earned low yields for a long time.

The insurance company, on the other hand, is focused on the long term. It invests the deposits it receives using a multi-decade outlook. It determines how much income to guarantee based on estimates of long-term investment returns. Those will be higher than what individual investors can earn on safe investments, though they are lower today than they were in the 1990s.

The odds are very low that an individual will accurately forecast interest rates well enough to identify the optimum time to buy an annuity.

Also, interest rates aren’t the primary factor insurers use to determine how much income to guarantee. Life expectancy is the main factor. Interest rates and investment returns are secondary.

Remember, a SPIA or DIA is purchased primarily to transfer risks to an insurer. You want guaranteed lifetime income sufficient to support your basic standard of living. Buy annuities when you’re at the stage of life that you want guaranteed lifetime income.

You maximize guaranteed lifetime income by shopping among annuity providers when the time is right, not by trying to time interest rates. My research over the years consistently found the guaranteed income among insurers with the top safety ratings varies by about 20%. Spend your time looking for the best annuity option for you instead of trying to time interest rates.

Another reason people don’t buy SPIAs and DIAs really is three related objections.

Acquiring an annuity involves depositing a relatively large amount of money with an insurer, relinquishing control and the potential to receive more than the guaranteed payments by earning higher investment returns.

That’s true, and it’s a reason to have only a portion of your retirement assets in annuities or other illiquid vehicles. Other resources should be available to pay for unexpected expenses or to take advantage of investment opportunities.

But most people don’t need 100% of their nest eggs in liquid assets. SPIA or DIA income should pay for regular, recurring living expenses. You’re going to have those expenses anyway and will need the steady cash flow to pay them.

If the lack of liquidity really concerns you, many SPIAs and DIAs now offer riders that allow you to withdraw some of your deposit in addition to the regular guaranteed income. Most allow the contract holder to withdraw up to 10% of the initial deposit during a year.

But there’s a cost. You receive a lower regular guaranteed income payments from the outset when you have this rider. Also, the future income payments usually are recomputed to a lower amount after you exercise the right to withdraw part of your deposit.

Another objection to annuities is the income payments aren’t adjusted for inflation. The income loses purchasing power over time.

You can buy annuities with income that increases each year by a fixed amount. You select the fixed amount, usually up to 5%. The initial income payments will be less than those of an annuity without this provision, and the income reduction usually is 25% or more.

It is better to recognize that the purchasing power of the annuity payments will decline over time. Plan to invest the rest of your nest egg to earn a return that in the future will supplement the annuity income and restore your purchasing power.

Also, keep in mind that most people spend less as they age, even after adjusting for inflation. So, you might not need a substantial supplement to restore the purchasing power and maintain your standard of living.

Someone who has significant wealth probably doesn’t need annuities. Even if the nest egg loses 50% of its value, a wealthy person should have enough resources to support his or her standard of living.  Heirs and charities will suffer the consequences of the portfolio losses.

Retirees who already have employer pensions or similar annuities, plus Social Security, might have enough guaranteed income.

People with relatively low lifetime incomes will receive enough in Social Security benefits to replace most of their pre-retirement income. They aren’t likely to need additional annuity income.

People who haven’t saved a lot of money for retirement probably shouldn’t put much money in illiquid vehicles such as SPIAs and DIAs. They’ll need the resources to pay for unexpected expenses while paying regular expenses from Social Security.

A little-known advantage of annuities and other guaranteed lifetime income is they enable people to spend more money and invest more aggressively with the rest of their assets than they otherwise would. See the November 2021 episode of my Spotlight Series online seminars for more details about these and other benefits of annuities.

SPIAs and DIAs are good vehicles for people who want principal protection for part of their retirement funds and also want to receive a fixed amount of income that’s guaranteed to last for life. (You can set the income to last for your life or for the joint life of you and your spouse.)

Decide how much principal you want protected and how much guaranteed income you want to receive for life. Then, shop for the best SPIAs or DIAs for you.