Why ‘annuity’ is not always a dirty word

Financial independence means living the lifestyle you choose without fear of running out of money. Whether to work becomes a choice, rather than an obligation. Activity (travel, hobbies, volunteering) does too.

Worst case from a lifestyle point of view is dying too soon. From a purely financial point of view, it’s living too long.

One challenge we face when helping clients reach their retirement lifestyle goals is projecting life expectancy. It’s as unknown as the other two unknowns: inflation rates and investment returns. No matter how hard we try to predict these things, we’re always wrong. The future is never the way we expect or want it to be.

If we could guarantee any aspect of the financial-independence scenario, it would improve our chance of success. Unfortunately, neither investment performance nor inflation can be guaranteed. It’s possible, though, to guarantee income. That’s a pretty good result, even if it comes at a cost.

Fixed annuities offer such a guarantee. They can provide a stream of income for life. The cost? A relatively low rate of return on capital, and when you die, there is nothing left for your heirs.

(Note that we are referring here to fixed annuities, not variable annuities or indexed annuities. The latter two flavors offer uncertain payments, high fees and potentially negative tax consequences.)

Cases in which adding a guaranteed stream of income to the retirement scenario are those where Monte Carlo simulations show a less-than-desirable success rate. Monte Carlo is a means of projecting thousands of possible futures by simulating variations we can expect in investment returns and inflation.

Traditionally, fixed annuities purchased for retirement have been SPIAs – single-premium immediate annuities. You take a lump sum, give it to an insurance company, and the insurance company provides you with a guaranteed payout for a certain period or for life. A new product, the SPDA, or single-premium deferred annuity, has been gaining popularity. Here, you pay a lump sum now with a promise from the insurance company to begin your guaranteed payments later.

Both the SPIA and the SPDA are transparent and consumer friendly, starkly different from their variable and indexed annuity cousins. They are pure risk-transference strategies. If the consumer is comfortable with the costs, they can be a valuable tool in the financial independence toolbox.

Now if we could only find a way to guarantee life expectancy… .