Who Should Buy an Annuity?

Who Should Buy an Annuity? 

by J. David Lewis, NAPFA-Registered Financial Advisor

In the last couple of months, we have spent quite a few hours helping an elderly lady obtain cash from an annuity, when she and her attorney were unable to locate the salesman who received a commission for selling it to her as an investment.  My belief is that annuities are not bad things, when understood and used for the purposes they are intended.  The problem is that they are often sold for reasons that have little or nothing to do with an indefinite stream of income, which the word “annuity” implies.   

The concept is simple.  To insure a specific cash flow for the remainder of your life, no matter how long you live, an annuity is the solution.  You give an insurance company an amount of money and they guarantee a stream of income.  When you die, if they have not repaid all you gave them, plus whatever it earned in their portfolio, they keep the remainder to pay those who live a longer time and support their profits.  If you die in a short time, your heirs could lose a lot.  If you live a long time, you can come out much better.  The certainty of being sure of “cash flow for life” is an attractive option when the decision is made clearly.    

A few of our clients have 403(b) retirement plans that require their participants to buy annuities with a significant portion of their accumulated accounts at retirement time.  Those sponsors appear to be attempting to protect their retiring employees from mistakes with their nest eggs.  It is a reasonable requirement.   

Social Security is a form of annuity.  We all pay in for most of our lives.  Social Security pays monthly income for the rest of our lives.  Social Security income stops at death, except for the smaller part spouses can receive until their death.    

To reduce the risk of heirs losing money, insurance companies offer optional terms that continue to pay heirs for a specified number of years, even if the buyer dies very early.  Although this choice reduces the monthly income, it should generally mean someone receives at least some return on the “investment.”    

Here is an example.  A husband, age 62, and wife, age 54, have $500,000 that could be used to buy an annuity stream of income for as long as either lives.  They have many options for investing this money.  For comparison, we used Vanguard’s website to test various annuity ideas.  Vanguard has a reputation for low cost investment options.  We stipulated that the monthly payments will continue for twenty years, even if they both die earlier, and that the survivor will continue receiving the full monthly payments as long as they live.  For the $500,000, Vanguard’s annuity will pay $2,223.88 per month for twenty years, plus as long as either of this couple is living.    

If both die within the first 20 years, the insurance company will pay $533,731.20, which is the total of 240 payments at $2,223.88.  If we think of this like a mortgage, the $33,731.20 additional in payments is interest through the years.  It calculates to an annualized return of 0.67% on the $500,000.  Of course, if either lives longer than twenty years, the return gets better.  Once the $500,000 has been received, the rest is return on investment.  Here is a table to illustrate how the annualized return improves if one of this couple lives beyond twenty years: 

If you live:    Your return is:
25 years 2.42%.
30 years 3.43%.
35 years 4.03%.
40 years 4.43%.
45 years 4.69%.
50 years 4.87%


From 1926 through December 2008 the annualized return for the S&P 500 Index was 9.6%.  Long term government bonds returned 5.7% over the same period.  Notice that December 2008 was at a very low point in the recent bear market.  A well balanced portfolio should provide returns somewhere in this range over twenty to fifty years.    

If this couple loaned someone $500,000, as a well secured 30-year first mortgage on their home and the interest rate was 4.25%, the monthly payments would be greater than the annuity – $2,459.70.  They would be 92 and 84 at the time of the last mortgage payment and their heirs could inherit the remaining balance, if they didn’t live that long.

So, an investor in an annuity’s stream of income essentially gives up the possibility of returns from a diversified long term portfolio.  In exchange, they should get peace of mind from the certainty of that monthly cash flow.  For many people, this peace of mind is well worth the potential portfolio return they forgo.  In the last twelve months, we have helped at least one person we consider relatively sophisticated understand this logic.  They decided to buy the annuity.  So long as they can understand their potential choices, we believe an annuity can serve a role in helping them enjoy their wealth.  For that client, we consider the project a success.     

I have sometimes commented publicly on annuities as investments.  An example is at Downside Protection Has Downsides – WSJ.com.  

Contact J. David Lewis directly with david.lewis@resourceadv.com or share your thoughts on this topic below. He founded Resource Advisory Services in 1985.  National Association of Personal Financial Advisors (NAPFA) was formed only a few years before. Lewis became a NAPFA-Registered Financial Advisor in 1986.  He is a passionate advocate for fiduciary, fee-only financial planning and has been associated with financial services since childhood in a banking family.  48399  

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