What Is an Annuity Really Good At?

There is One Thing An Annuity Does Really Well

An annuity gets the 1st Place ribbon for one thing that it does an outstanding job of - providing a longevity hedge. Tim Hawley/Getty Images

There is one thing annuities are great at. To understand what it is, you need to know that annuities come in about as many breeds, shapes, and sizes as dogs do. Ready for a crash course on annuities? Here we go. (You'll find the 'one thing' answer in item 3 below.)

One: All annuities are not alike

Do you know how many different types of annuities there are? Immediate annuities, inflation-adjusted immediate annuities, variable annuities, variable annuities with guaranteed income riders, deferred annuities that function as a form of longevity insurance, annuities with long-term care riders, fixed annuities, equity index annuities, equity indexed annuities with guaranteed income riders...

Whew! That’s a lot! And yet we use one-word “annuity” to lump all these diverse products together.

Each type of annuity has a set of features and benefits that might work quite well as part of your long-term retirement plan... or it might not. It depends on what you need your money to do for you when you need it, and what types of trade-offs you want to make. Each one is a bit different. When you hear the word annuity, don’t stereotype.

Two: All annuities have one thing in common

All annuities are insurance products. They are policies issued by insurance companies. If you want to shift risk certain types of risk (investment risk, longevity risk) to an insurance company, an annuity is one way to do it.

Shifting investment risk occurs when you buy a fixed annuity. The insurance company takes your money, they invest it, and in return, they pay you a guaranteed fixed rate of return. They bear the investment risk, not you.

Shifting longevity risk occurs when you buy an income annuity that pays you a guaranteed monthly income for the rest of your life. No need to worry about outliving your money anymore; this risk has been shifted to the insurance company. And this is the spotlight feature of annuities.

Three: There is one thing an annuity is really good at

There is one thing an annuity is great at.

That is to hedge longevity risk; the risk that you might outlive your income.

For clients who want to protect themselves against this risk, immediate annuities, longevity insurance, single premium deferred annuities, and variable annuities with a guaranteed withdrawal benefit or guaranteed income benefit feature should be evaluated and considered.

Why is an annuity so great at protecting against longevity risk? Because of something called mortality credits. In any given pool of people at any given age, some are going to live long and some are not. If you buy your income annuity at age 70 or older, the annuity companies can provide a higher payout to you; something akin to a higher rate of return because of the way these mortality credits work. It’s another way to get a potentially higher return on your money, but most people won’t look at it this way.

Four: What to watch out for with annuities

Annuities can be restrictive and expensive when they are used inappropriately. The thing to keep in mind: an annuity is a tool. That’s all. If you talk to someone who makes their money by selling annuities, they are going to expound upon the benefits of their tool. If you talk to someone who can’t make any money selling annuities, they are going to tell you why you should never buy one.

If you talk to someone who makes their money delivering objective advice, they’re going to help you decide if the right annuity would provide a benefit for you, and they are going to help you compare it to other options.

Five: Who buys an annuity

In numerous surveys, upcoming retirees say their number one fear in retirement is running out of money. An immediate annuity or longevity insurance is the perfect choice to protect against this outcome. And yet few people buy them.

Why is this? It doesn’t make sense.

I think people do not understand the products, and, honestly, I think a lot of people think they won’t live that long.

Not me. I’m fascinated by the world and the things us humans do. I want to see as much of it is possible. An annuity will likely be a good choice for me.

What about you?