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.