Fixed Annuities and Financial Risk

This baby boomer and no doubt many others are giving more consideration to fixed annuities as alternative investment vehicles.  Fear of more market losses and a need for a reliable source of retirement income is driving this.
A fixed annuity is a contract in which you surrender a lump sum of money to an insurance company in exchange for a guaranteed monthly income.
Theoretically, this removes market risk from the investment.   However, I think that baby boomers need to carefully assess all of the financial risks associated with fixed annuities before making a purchase decision.  In my mind, those risks include inflation risk, death and survivorship risk, and company failure risk.

Annuity Inflation Risk

Unlike Social Security retirement benefits, most fixed annuities are just that: fixed.  There is no annual cost of living or inflation adjustment.  Therefore, the monthly payment you contract for this year may not buy you much twenty years from now.  Annuities with inflation protection are available but they are significantly more expensive.

As one example, at my age and in my state, I can spend $100,000 for a single-life annuity from Vanguard that will pay me $622/month for life.  If I use that same $100,000 to purchase an inflation-adjusted fixed annuity, my initial monthly benefit is reduced to $454.  That is a significant difference.  Nevertheless, depending on how much of your retirement nest egg you intend to use for an annuity, you need to give careful consideration to including some level of inflation protection in the annuity payout.

Annuity Death and Survivorship Risk

In a conventional fixed annuity, once you have surrendered the premium to the insurance company, its gone. You may die after receiving only one monthly benefit payment but the insurance company won’t give your estate any of your money back.  There are lots of options that would change that outcome but, of course, that changes the premium you will pay.  

The other aspect of the death risk is what happens to your surviving spouse.  Again, in a standard single-life annuity contract, your survivor receives nothing.  From an income point of view, that may not work out well for your spouse.  That is why you should consider a joint life annuity to reduce the death risk.

Again as in my example, my $100,000 premium can be used to buy a Vanguard annuity that will continue payments for the life of both spouses.  That monthly benefit would be $539 compared to $622 for the single life annuity.

Annuity Company Failure Risk

Annuities are not financial instruments that are guaranteed by the FDIC, SIPC, or any other agency of federal government.  If the insurance company that issued your annuity contract fails, no one in the federal government is obligated to bail you out. 

Most states have state guaranty associations that provide some protection to policy holders in their state if an insurance company doing business in that state fails.  In most cases, the limit of such protection (if it exists at all) is $100,000.  (Here is an unofficial list of state guarantee association limits.)  

As a risk control strategy, you should contact your state insurance commissioner and confirm that your state has a guaranty association and, if so, what limit would apply to an annuity contract.  Using that information, you should then consider dividing your annuity protection among more than one insurance company so that you receive the maximum possible protection.

I also suggest that you check the financial stability and credit ratings of the annuity insurance companies you are considering.  You can do that at A.M. Best and at Standard & Poor’s.  

Concluding Thoughts on Fixed Annuity Risk

Fixed annuities can play a helpful role in an overall retirement income plan.  (Consumer Boomer offers another take on fixed annuities for baby boomers.)   I plan to continue my research and study but want to wait and see which annuity companies emerge strong from the current economic mess.  I also want to assess if and when the equity markets might rebound and what will happen with inflation.  Only then can I make an informed judgment about the risks and benefits of purchasing a fixed annuity.


Comments

  1. Dave says

    Very good summary of the risks and rewards of immediate annuities! For Baby Boomers, immediate annuities will be the “silver bullet” that will help mitigate market risk, but only if:
    1. They are phased in over the retirees lifetime i.e. $100,000 annuities today, $100,000 annuitized in five years, etc. This helps alleviate inflation risk and gives one time to allow beaten-down stocks to grow again. It would work very well for someone who retires in stages i.e. from full-time to part-time to full-retirement.

    2. Joint lifetime annuities are a must for couples. Sure, the payments are a bit smaller but why leave your partner broke just because you die first.

    3. Shop around and spread your annuity risk over different companies with at least AA ratings. The old saying “don’t put all your eggs into one basket” applies here.

    4. A guaranteed income stream may help retirees hold off getting Social Security until they are 70, therefore giving them the ultimate inflation-adjusted annuity.

  2. Frank says

    Good primer on immediate annuities. I can understand the appeal of a steady income, but you’re not really avoiding market risk, you’re betting that the insurance company can invest your money better than you can. You are also effectively purchasing an insurance policy that you may or may not need. Inside every annuity is a bet by the insurance company that you won’t live beyond the average life expectancy for a given age. If you win that bet, an annuity provides an attractive payoff for your premium.

    One additional risk has effectively eliminated immediate annuities from consideration for me: loss of control. Once you purchase the immediate annuity, you’ve lost control of those funds in exchange for a guaranteed income. I’d rather decide how to invest the money and decide when and how much I wish to withdraw.

  3. says

    Annuities are right for a certain type of people in my opinion. To the type that see annuities as an easy way to contribute to their retirement accounts at no real hassle, then great, but the type that keep up with the economy/stock market could almost certainly beat the returns they could get from a fixed annuity by investing in an index fund.

  4. Greg says

    I have been an agent for 25 years and your article is misleading. You dont even talk about the potential growth of an fixed equity index annuity with an income rider to hedge your bet. An annuity from Aviva or Allianz is a great buy for most people looking for safe income for the future. The federal legal reserve system is one of the best protections for life insurance and annuities avaliable to any financial vehicle in this country.

  5. Mr. GoTo says

    Greg: I do not think my article is misleading. I don’t even talk about equity indexed annuities, which in my opinion are an entirely different product. I have actually studied equity indexed annuities myself because many people have tried to sell them to me. I do not find them appealing for a lot of different reasons. Most experts who are not in the industry tend to agree.

  6. Wayne says

    Mr. GoTo: I have an opportunity to buy an indexed annunity tied to the s&p with a guarantee of 5% should the s&p fail to rise in any given year. The “floor” is re-set each year and I get the percentage of any gain. Good for 10 years. Sounds too good to be true. Am interested in your comments given you find them non- appealing for a variety of reasons. the agent selling it claims it is a “fail-safe” way to reap the gains with no risk, a claim I find hard to believe. Thanks for your input.

  7. says

    You seem to have Fixed Annuity and immediate annuities confused…The State Guarantee Fund is $250,000 in many states. Yes I am an agent and I too dissagree with your misleading comments. As far as the Fixed Index Annuity;I have had clients lock in gains over 49% and that was after not losing the prior year, but earning a ZERO. Compared to direct market investors that lost nearly 50% and then if lucky came back nearly 50%, STILL NOT EVEN WHOLE YET! If you only have a year or two and need to spend all your money then do not go into a Fixed Index Annuity. If you want to have your money growing for a long while then a Fixed Index Annuity cannnot be beat. With the standard Penalty Free access of 10%, that’s nearly 10 times what a CD allows.

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