Co-produced with PendragonY.
Annuities are a very controversial topic. Most people either love them or hate them. For the most part, I think these strong opposing views come from a misunderstanding of the role annuities can play in securing people’s retirements.
At their most basic level, an annuity is a contract that, in exchange for a premium, will pay out a set amount of money over a specified period. For retirement purposes, an annuity takes some payments upfront and then, over time, pays out some calculated amount of money regularly. Most such annuities are structured to make payments to the holder for the remainder of their lives to secure a minimum retirement income.
This basic level of annuity is designed to remove the risk of a retiree running out of money before they run out of life. This is why insurance companies sell them; annuities are a form of insurance. “Life” insurance is the protection for your heirs against you dying young. Whereas an annuity can be considered insurance for yourself against living too long.
While there are many different forms of annuities with lots of bells and whistles, I think it is best to keep in mind that they are primarily an insurance product. The purpose of an annuity is to shift the risk of running out of money to the insurance company; and at an acceptable cost.
Types of Annuities
There is a large number of different annuity structures available. But they all boil down to a combination of risk characteristics (either fixed or variable), and payment options (either immediate or deferred). All annuities offer you the safety of being offered by state-regulated insurance companies (although you should always confirm that the company is highly rated). They also offer tax-deferred growth with higher interest rates than bank offerings. You can also make unlimited contributions, which can be very important to high-net-worth individuals. And most important of all, they offer you the safety of never outliving your money. You can get more details here.
Many articles can be written comparing different annuity options. However, I tend to prefer the K.I.S.S action (Keep It Simple, Stupid); I think the best choice is one where you pay cash upfront to get a fixed monthly payment for the rest of your life. Adding a death benefit and inflation protection might also be worth it.
Remember that the primary purpose of an annuity is to transfer the risk of running out of money to the insurance company. The further an annuity feature you purchase from that basic purpose, the less efficient an annuity will be at doing that. If you want the best steak, go to a steak house, not a seafood restaurant.
Annuity Outcome Analysis
When picking out an annuity, it pays to shop around. Each insurance company uses slightly different risk models and portfolios to generate the income they will pay you. Those differences can be significant. So, once you have decided on an annuity, get quotes from several companies and pick the one that offers you the best deal.
Let’s use the following website to calculate an estimate for the benefit of an annuity that costs $100,000. My calculation parameters are Male, 61, and living in Virginia. The website tells me that for $100,000, I can get an annuity that will start paying me $579 a month until I die. That is $6,948 a year. Notice that it is roughly 6.95%, which is both interest and return on capital. But is this a good deal?
One way to determine if this is a good deal is to compare the annuity’s performance to something else. For this, I am going to use a tool called a Monte Carlo simulation. Essentially, the tool uses the investment’s past returns to predict possible future outcomes. It runs a large number of such simulations, typically 10,000. In a statistical sense, this gives you an idea of what the future might hold. I am going to use it here to determine how likely or unlikely it is that a portfolio will run out of money. In this case, it will be a portfolio with a starting value of $100,000 with a monthly withdrawal of $579.
To keep things simple, I am going to compare the results of a simple annuity to that of an equal investment in just one pick from the HDO model portfolio, Realty Income Corporation (O). Realty Income has been around for a long time. Since 1969, they have declared 632 consecutive common stock monthly dividends and increased dividends 119 times since their public listing in 1994. The dividend is well-covered and is increased each quarter with usually one big increase and three smaller ones. It has certainly earned the name The Dividend Company.
So how would an investment in O likely perform over the next 30 years? As it turns out, it’s not too bad. To ensure that I wasn’t being too optimistic, the tool I used allowed me to consider the sequence of return risks. So I ran the simulations assuming that the first year of the simulation was the worst-ever performance for Realty Income. Over 30 years, only 316 of the 10,000 simulations show the portfolio running out of money. Looking at the 10th percentile (which means that 90% of the portfolios do better), the portfolio has $347,879 left in it. 95% of the portfolios had more than the starting $100,000 in them after 30 years. This means that there is very little risk that you will run out of money over those 30 years and an even lesser risk that you will run out of money if you need it for a bit longer than 30 years. In fact, even if you increase the simulated period to 35 years, the 10th percentile balance is around $580,000, and only 51 more portfolios ran out of money. Using these figures, you can determine whether the reduction in risk offered by the annuity is worth it to you.
I also ran the numbers with the annuity returning the residual value if the holder had died early. This means that the holder will collect at least $100,000 no matter when death occurs. This costs an extra $6430 to generate the same $579 monthly benefit. But in the simulations using Realty Income to generate the income, 90% of the simulated portfolios are ahead of the annuity after 5 years even without the extra payment. At 61, even with my high blood pressure and high blood sugar, I don’t think paying extra to keep the residual is worth the cost.
The figures change as the investor gets older. Starting at 71, the same $100,000 premium buys an annuity that is estimated to pay $730 a month. In that case, only about 92% of the portfolios survive 20 years.
The HDO model portfolio has a current yield of 9.7% and a CAGR on total return of 10.2%. Realty Income has a current yield of 5.1%, roughly half of the HDO model portfolio’s current yield. Since 2016 (when HDO started), its total return CAGR is 7.9%. So, over the long haul, the HDO portfolio produces much more recurrent income than Realty Income and probably any annuity you can find out there. It also produces significantly more upside. With proper due diligence and some changes in weighting, you can tailor the amount of risk and upside you get.
Annuities come with a wide range of options, and understanding how all those options work together can be confusing. Some of these options might create the illusion that you are participating in the stock market. End of the day, remember that annuities are insurance, not an investment.
Insurance is all about transferring risks to another party for a price. Make certain that you transfer only the risks that jeopardize your retirement plans and that you are comfortable with the price you pay to transfer that risk. There is certainly a role for various insurance products in a comprehensive retirement plan – life insurance, long-term care insurance, health insurance, liability insurance, an umbrella insurance policy, and even annuities can all play a role in protecting the wealth you have worked so hard to accumulate in your life. Make sure you understand what you’re paying for these products and, more importantly, what they protect you from. Nothing is more frustrating than an insurance product that doesn’t quite work the way you thought it should.
For your investments, I favor an income method. Using your dividend stocks to generate a recurring stream of income that is larger than you need to live off of creates a comfortable margin of safety and reduces the need for you to pay premiums. We do so through a “Model Portfolio” which currently yields +9% as part of a retirement solution.
Our income method produces regular income from dividends, distributions, and interest paid by our holdings. Having a minimum of around 40 investments, which are chosen for the ability to support cash payments to holders, helps ensure a diversified and dependable income for your retirement needs. This is the beauty of being an income investor! You do not need to worry about market gyrations. You can rest and enjoy life while your investments work hard for you!