Annuities, Once More, With Feeling

Picture Credit: Mike Cohen || Ordinarily, the only annuities worth buying pay income at some fixed date, whether present or future. Oh, and they aren’t variable annuities.

I’ve written a number of articles on annuities. Here are a few examples:

• Dishonest Annuity Advertisement
• On Fixed Payment Annuities
• On Annuities, Particularly Variable Annuities

In general, I don’t think anyone should buy variable annuities, with some rare exceptions where the actuaries pricing the policies have mispriced the guaranteed portion of the benefits too cheaply. I have seen this about a dozen times in my life. Actuaries are not quants (me and a few others excepted), and so some of them don’t get option pricing. But actuaries tend to be conservative, and so they don’t typically offer a free lunch.

Annuities are typically an expensive way to get returns. Typically, the all-in expenses of annuities range from 1.0-2.5%/year. As such returns are typically poor.

But there is one competitive portion of the annuity market, which is where companies compete to pay a fixed income to people, whether presently, or at some future date.

This article was prompted by three articles at Morningstar. Here they are:

• Using Annuities During Retirement
• Why the Government Should Learn Which Annuities Are Useful
• Should We Have More Annuities?

Morningstar basically agrees with my point of view on annuities. They like annuities that have fixed terms and pay out income.

Now, these annuities have two risks: default and inflation. But they come with a benefit — longevity insurance — they pay as long as you live.

Default risk is minimal as you have the state guaranty funds backing them up to $250,000 of present value. Like CDs that risk can be mitigated by buying multiple fixed payout annuities from many companies, keeping the amount invested under $250,000.

Inflation is not a solvable issue. It is better to treat your annuity as a part of you bond portfolio, invest the remainder of your bonds at short durations, and invest in stocks, especially cyclicals and dividend-payers. That is a reasonable approach to hedging inflation.

Morningstar’s policy recommendations to the US Government are reasonable, but I would not think they are crucial to most people. If you are motivated, you will find ways around the restrictions. If not, you pay more taxes. Well, someone has to pay it.

Summary

In general, insurance is meant to hedge risks, and not be an investment. If you are hedging longevity risk, fixed payout annuities can be a useful part of your portfolio. Otherwise, avoid buying annuities.