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Is an Immediate Annuity Right for You?

Often viewed as an archaic investment vehicle, immediate annuities deserve recognition. Like any financial tool, they aren’t for everybody. But in the right circumstances they can mean the difference between running out of money during your lifetime and having income for life.

An immediate annuity is an insurance contract that promises a set amount of payments for a certain time period. Payments can be over the lifetime of the annuitant or a fixed term; they can also be paid over joint life expectancies; the payments can be adjusted periodically with inflation. All these riders come with a cost that is in the form of a lower periodic payment. The way to view a immediate annuity is as a type of insurance policy; to protect against the risk of longevity and transferring the investment risk to the insurer. So if you buy a immediate lifetime annuity, you can live beyond 100 and the payments will still keep coming, reducing the risk that you deplete your lifetime savings.

The key here is that an immediate annuity can be used as a psychological tool to manage one’s risk tolerance. Immediate annuities in the simple form can be expected to produce a rate of return similar to a bond portfolio. But the value of the bond portfolio can rise and fall with interest rates. And there is re-purchasing risk where a bond or CD can mature at the low end of the interest rate cycle with the funds reinvested at a lower interest rate. By buying an immediate annuity, you are eliminating the re-purchasing risk. With the knowledge and comfort that they are going to get a guaranteed payment on a periodic basis, this allows some to take more risk in their portfolio as a whole.

With any financial vehicle, there come trade-off’s. And there are several negatives. The biggest risk with an immediate annuity is pre-mature death; once it’s gone there is nothing left to the estate. So essentially when you are transferring the risk, you also transfer the terminal principal. Also inflation is a consideration as the value of the guaranteed payment will lose it’s purchasing power over time. So what could of bought you a months worth of household expenses today may not do the same five or ten years from now. Some of a retiree’s larger expenses, leisure and travel in the early years, medical costs in the later years and potential long term care costs all are growing at rates 2%-3% above inflation. Now there are riders that you can attach to the annuity for spousal survivorship or a guaranteed fixed period if you die prematurely or inflation adjusted increases in the payment over time. The only problem is this becomes costly as inflation adjustments can reduce the payments for a 60 year old by 30%; survivorship clauses can reduce it another 10%-20%. Also a portion of the annuity is taxed as ordinary income, which eats away at the monthly payment. This is less efficient than capital gains or qualified dividend taxation at this time. Also with our tax structure, I expect that ordinary income tax rates will go higher rather than lower in the future. Also we are still on the low side of the long-term interest rate cycle. Buying a fixed immediate annuity today may not look so good down the line if we have a secular period of gradually increasing interest rates. You could buy several contracts over time, but sometimes this isn’t the most optimal solution. Finally, you lose flexibility once you buy the annuity, because you lose the opportunity to adjust that portion of the portfolio if needs change, if the portfolio needs to be rebalanced or if there is a tactical opportunity to enhance your risk adjusted return; once it’s done, you own it.

So when do immediate fixed annuities make sense? I like them in situations when:

-The investor is extremely risk averse and needs additional growth in the portfolio to meet their needs. For example, if the client would have left the money in a cash equivalent, the annuity may provide them with better return characteristics while allowing them to sleep soundly at night. Or if the comfort of a certain payment to cover their essential ongoing household cash flow needs today would make them more willing to invest in stock, which will provide the higher real returns take care of their long term needs or

-If the investor has a significant amount of funds to more than take care of their lifetime needs, the fixed immediate annuity is a good tool to provide funds to help keep them within a certain budget or offer an additional layer of diversification to the overall portfolio and……

-If the investor is not concerned about leaving an inheritance. So for the person who’s main goal is principal preservation, buying an annuity may be counterintuitive because they will give up their principal, but in turn it may increase their chances of not running out of money during their lifetime. For the conservative investor, it may be a nice diversifier within your portfolio allocation towards bonds.

In the end, something to consider. Just don’t confuse this with a variable annuity because that is a vehicle better off avoided in most cases.

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