Who Needs an Annuity and Why?

My clients might well be surprised to see this post—I spend a lot of time railing about the over-selling of annuities and the hefty commissions that go to the advisors who sell them. But the annuity has a long, respectable history and can actually be a good financial tool for the right situation. So what is that situation?

First, it helps to know how annuities work. They aren't quite as dreary as they sound. Way back in the 17th and 18th centuries, annuities were a great way for a very wealthy person to fund the retirement of a widow, an artist or a beloved servant. For that matter, they were one of the original prizes in government lotteries. Essentially, an annuity is a contract that gives the beneficiary the right to receive a certain sum of money every month or every year for the remainder of his or her life. Sounds great, right?

There is a little more to it, though. These days, annuities are insurance products. Like any insurance policy, the insurance company has used statistics about people's life spans to predict how much they need to charge you (and how much they could pay to the beneficiary) in order for the insurer to make a profit on the deal. So, for instance, Wholesome Life Insurers, Inc. are happy to sell you an annuity that costs $100,000 up front and pays $20,000 per year to your Aunt Betty for $100,000 if they think she'll drop dead after the second year of payouts.

And there are necessary costs. In addition to paying the people who sell you the annuities, the insurance company needs to pay people to file the required reports, process the applications, run the office, etc... That isn't all, though. In point of fact, your insurance company is hoping to make most of their profit by investing your initial $100,000 until it needs to be paid out. For that, of course, they need to pay investment managers. All of these costs are built into how much the annuity costs you.

So why not just invest the $100,000 yourself and skip the other costs? This is the question at the heart of the matter when it comes to annuities. In most cases, it is cheaper to fund your own (or your Aunt Betty's) annuity. But relying on your $100,000 investment to grown enough that it can pay you back the money you need in retirement is a gamble—a gamble on the investments and a gamble on your lifespan not going longer than planned.

In the Bloomberg article with which I started this series, David Little, Director of the Retirement Income Planning Program at the American College of Financial Services, chose to take care of most of his own investing, trusting that he would do better than the relatively high fees and low returns that an insurer would get. But he also purchased an annuity as a supplement to the investments. The annuity offers him a baseline amount that he will get every month during retirement to prop up his social security benefits in case the investments disappoint or in case he lives to, well, 103.

As Little's plan suggests, annuities make sense in those instances when security matters to you much more than cost. Whether it's being able to insure a comfortable living for your Aunt Betty, or locking in a baseline for yourself, annuities are about covering a basic need—often psychologically as much as financially.

Just one last note on annuities—there is no such thing as a "guaranteed" investment. Make sure you feel as confident about the insurance company you buy from as you do about your choice to buy. If you want to learn more about the types of annuities out there, check out the SEC's online guide to annuities.

What if you live to 103?

This weekend Bloomberg News featured an article by Suzanne Woolley about the perils and conundrums of trying to plan your finances around our increasingly long life spans. For the article, Woolley interviewed David Little, Director of the Retirement Income Planning Program at the American College of Financial Services. Unlike the standard use-your-401k, retire-later advice articles, Woolley's piece delved into how Littell was personally wrestling with decisions about home, work and family. For the next two weeks, I want to use my posts to look more closely at some of the questions raised in Woolley's article—the real decisions that make up long-term planning.

According to the article, Littell faces some fairly standard challenges when it comes to his long-term finances. At 61 years old, he earns in the low six figures and has diligently put a way money regularly in 401k's and other tax deferred accounts,  but he has a partner whose recent retirement has him thinking about how he could cut back on work in a few years. More importantly, he's wondering how to account for the fact that his father, who retired at the ripe old age of 75 is now 103 years old.

Littell's father brings him (and us) face-to-face with a new reality. Most of us in GenX or the Millenial Generation have already decided that "retirement" is likely to be more of a stress-reduced continuation of our work lives, whether because we won't be able to afford a full retirement or because we simply dislike the idea of having nothing important to do for a few decades. But even as advisors like me push our client plans to the age of 99, and workers look to 70 or 75 as a more appropriate "retirement" age, life spans (and "retirements") seem to keep getting longer.

In thinking about how to address this challenge, I want to look at a short list of the tools, strategies and personal questions that will become increasingly important to all of us:

Not Real Work: The Low-Stress "Retirement" Career

Social Security's Strange Schemes

The Unpredictable World Of Health Care (and Long Term Care Insurance)

The Retirement Account Menu

Annuities: The Oldest (And Most Confusing?) Retirement Accounts

When Is A Home A Home?

Retiring Abroad

Have another topic you want to see on the list? Leave a comment or send me an email, and I'll throw that one in, too.