Annuities, and when they are worth considering

Annuities attract strong opinions in both directions. The category is broad enough that general statements about it are usually wrong.

The problem they address

Longevity risk — the possibility of outliving your assets — is difficult to manage with investments alone, because it requires planning for a lifespan you cannot know.

Insurance is the natural mechanism for this kind of risk. Pooling across many people means those who die early subsidise those who live long, which allows a higher sustainable payout than any individual could safely take alone.

That is the genuine economic case, and it applies specifically to income annuities rather than to the category as a whole.

The types

Single premium immediate annuities. A lump sum in exchange for payments beginning immediately and continuing for life.

Simple, comparable between providers, and the closest thing to a pure longevity insurance product.

Deferred income annuities. A lump sum now for payments beginning at a defined future age, often in the eighties.

These are efficient longevity insurance precisely because they only pay in the scenario being insured against, which makes them cheaper per dollar of protection.

Fixed annuities. Essentially a guaranteed rate product, comparable to a certificate of deposit with different tax treatment and different guarantees.

Variable annuities. Investment accounts inside an insurance wrapper, frequently with optional guarantees attached.

This is where most of the criticism is directed, generally on grounds of cost and complexity.

Indexed annuities. Returns linked to an index with caps and floors, subject to formulas that are frequently difficult to evaluate.

The reasonable criticisms

Cost. Variable and indexed products frequently carry layered charges — mortality and expense fees, rider charges, underlying fund costs — that materially reduce returns.

Complexity. Products whose payout depends on formulas the buyer cannot evaluate are difficult to compare and easy to misunderstand.

Surrender charges. Many products impose substantial penalties for early withdrawal, sometimes lasting years.

Sales incentives. Commissions on some annuity products are high, which affects what gets recommended.

Irreversibility. An immediate annuity generally cannot be undone, which is a real cost in flexibility.

The case in favour, narrowly

For a specific purpose, income annuities do something nothing else does.

They convert a lump sum into guaranteed lifetime income, which removes longevity risk from the portion of the portfolio used.

Research on retirement income has generally been more favourable to simple income annuities than the popular commentary suggests, particularly for covering essential expenses not already met by Social Security.

The framing that makes it clearest: an annuity is not an investment competing with a portfolio. It is insurance, and it should be evaluated as insurance.

Practical considerations

Cover the gap, not everything. The common approach is to annuitise only enough to cover essential spending after Social Security and pensions, leaving the rest invested.

Inflation. Most immediate annuities pay a fixed nominal amount, which loses substantial purchasing power over a long retirement.

Inflation-adjusted versions exist and are considerably more expensive, and the market for them has thinned.

This is the most serious weakness of the product and it is frequently glossed over.

Interest rates matter. Payout rates depend heavily on prevailing rates at purchase, which means timing has a real effect.

Insurer strength. The guarantee is only as good as the company. State guaranty associations provide some protection with limits that vary.

Spread purchases. Buying in tranches across several years reduces the effect of buying entirely at an unfavourable rate.

Who should probably not

Those with substantial guaranteed income already covering essentials.

Those with health conditions materially reducing life expectancy.

Those whose primary goal is leaving assets to heirs, since most income annuities pay nothing at death unless a costly guarantee is added.

Those being sold something they cannot explain in a sentence.

The questions to ask before buying

A short list that filters out most unsuitable products.

What is the guaranteed payment, in dollars, per month?

What are all the fees, stated as an annual figure?

What are the surrender charges and how long do they last?

What happens if I die in year two?

What commission do you receive?

Can I have three competing quotes for the same guaranteed income?

That last question is the most useful, because immediate income annuities are directly comparable between insurers and quotes vary meaningfully.

General information only, not financial or insurance advice. Annuity products vary widely — consult a qualified fee-only adviser about your own situation.