Annuities are insurance contracts designed to provide individuals with a guaranteed stream of income for life1. They can serve as a crucial tool in retirement income planning and have some creative uses in estate planning. In the current interest rate environment, annuity payouts have a bit more juice when compared to contracts written over the recent decade. Although there are several different types of annuities, let us keep things conceptual for now and focus on overall risks and considerations.
Two fundamental risks associated with annuities are liquidity risk and longevity risk. These are the primary risks that are exchanged between the annuity owner and the insurance company.
Liquidity risk refers to the risk of not being able to access funds when needed. In the case of annuities, once the annuity buyer sends the lump sum of cash (single premium) to an insurance company, their access to that principal amount is limited at best. More commonly, the premium is completely inaccessible. The annuity owner takes on liquidity risk and is compensated for that risk by the insurance company with a guaranteed stream of cashflow. The insurance company (who has effectively decreased their own liquidity risk with this transaction) is now responsible for ensuring that the annuitant receives their payments on time, regardless of economic conditions.
Longevity risk is the risk of outliving one's savings. In retirement income planning, individuals often worry about the possibility of running out of money before they pass away. By purchasing an annuity, the annuity owner lays off longevity risk to the insurance company. Your own longevity is now a risk to the insurance company, and it is their responsibility to invest the premium carefully.
The Exchange of Risks - Considerations
This exchange of risks is particularly beneficial for individuals who live longer than expected whereby they will continue to receive payments, providing a source of income even in their advanced years. Before even considering an annuity, a potential buyer must understand this exchange, as they are essentially transforming the risk profile of their balance sheet. Here are some additional considerations to help you determine if an annuity might be right for you.
You are a Risk-Averse Investor
Annuities can be well-suited for individuals who prioritize financial security, guarantees, and are risk-averse. If you are concerned about outliving your savings and already maintain a conservative investment portfolio, annuities might be practical addition to your balance sheet.
Individuals with No Pension
If you do not have access to a traditional pension plan through your employer, annuities can help fill this gap. An annuity can act similarly to a personal pension, providing you with a source of income during your retirement years.
If you have a family history of longevity, annuities can provide consistency. They ensure that you receive income for as long as you live, regardless of how long that may be.
Overall Access to Liquidity
Do you have access to cash and/or liquid investments for unexpected emergencies? Roof blown off by a tornado? Car swept away in a flood? Unexpected medical emergency? Getting sued by your neighbor after they tripped on your property? All the above happen at once? Being properly insured is always optimal, but life has a way of throwing curveballs that you will need liquidity to initially navigate. Annuities are great for what they are designed to do but consider your overall financial picture from a balanced perspective.
Spousal and Survivorship Considerations
Annuities can also be suitable for couples who want to ensure financial protection for both spouses. Joint and survivor options on annuities provide continued income to the surviving spouse after the primary annuitant passes away. This option is beneficial for couples who want to guarantee financial security for the surviving partner.
Inflation and Legacy Considerations
Ideally, annuitization should be viewed as a tool to manage your cashflow, risk profile, and longevity concerns. Paradoxically, being overly conservative can introduce rather insidious risks as well! Many retirees will still need to own some degree of risk assets so that they can maintain purchasing power as time passes.
If you intend to leave a substantial legacy to your heirs, understand that unless you are specifically utilizing other types of annuities within the context of an advanced estate planning strategy, you are giving that lump sum premium to the insurance company, and that is who it will stay with. There are death benefit riders and guaranteed period certain options available for some annuities, but we will save those considerations for another post.
The exchange of liquidity risk and longevity risk is a delicate balancing act. Many investors utilize bond yields to satisfy their retirement income needs, but as we saw in 2022 (and continue to experience), bond market volatility is a reality. Bonds always carry risk (just different types of risks when compared to equities, commodities, etc.) and we are simply seeing those risks manifest after over a decade of interest rate suppression by central banks. Historically, what we are experiencing right now with interest rates is not particularly unusual, it’s just been awhile! I believe now is a perfect time to open the door to a conversation about how annuities (or other alternatives) might assist you in your retirement planning.
Material discussed is meant for educational purposes only and is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice. Annuities are long term investment vehicles designed to help investors save for retirement and involve certain contract limitations, fees, expenses, and risks. All guarantees including the death benefit payments are dependent upon the claims paying ability of the issuing company and do not apply to the investment performance of the underlying funds in a variable annuity. 2023-163392 Exp 10/25