When we think about long-term family financial planning, there are two main areas we tend to focus on: investment, and insurance. Usually that means stocks and bonds, or life and long-term care insurance. But there’s something else we want to take a closer look at: Annuities. With this article we’ll introduce you to them, explaining what annuities are and whether they are right for you, including their advantages and disadvantages.
The logic holds that it’s best to plan for two inevitable possibilities: you’re either going to live to a ripe old age, or you’re going to pass away earlier than you might expect or hope. Having a long-term plan that accounts for both possibilities, and still provides financially for our children and grandchildren is a nice thing indeed.
But every plan has its failure scenarios. What happens, for example, if we live much longer than we might have expected? How can our long term planning account for this happy potential outcome? What happens if, for example, we live so long that our lifelong retirement savings and investments turn out not to be enough to help us live comfortably in that distant future, when we’ve been retired for decades, and haven’t worked a regular job in 30 or 40 years?
While on the one hand, that may seem like a dream come true… There’s also a good reason why most retirement plans don’t account that closely for the idea that we’re going to live to see our children, and possibly their own children, reach retirement age.
But I can tell you from personal experience, that long-lived members of a family can present a financial challenge for their descendants, particularly if those superannuated family members live long enough to see their own children reach beyond the typical lifespan themselves.
My grandfather, for example, reached an age at which visiting and spending time with his own mother, who lived well into her 100s, proved difficult. Providing for an aged parent on the fixed income of a senior citizen is not easy. Yet this problem is only going to get worse. Healthy people are living longer and longer thanks to modern medicine and technology, but we’re also having fewer children than we used to. Therefore planning for the eventuality that you may outlive your expected lifespan is good sense.
Annuities: A Hedge Against A Long Life
Just like life insurance functions as a “hedge,” or a “bet” against the possibility of dying relatively young, annuities are useful retirement planning tools for those who may face the opposite problem: that of living “too long.”
While there are many flavors of annuity, in broad strokes, these are investment vehicles that behave more or less like insurance contracts, which will pay out when a person reaches a certain age. They may involve having the retiree’s money invested in other financial instruments, or they may be purely insurance contracts, which will only pay out when a certain amount of time has passed. Some are set to pay out for a certain number of years, while others may pay out for life.
Lifetime Annuities
If you’re a risk-averse person who has a reasonable expectation that they’re going to live to an advanced age, then a lifetime annuity might be right for you. People purchase lifetime annuities because they don’t expect the support of either the state or their children (if they have children), but they have enough money to feel reasonably secure in their retirement. For those with a modest lifestyle and no expectation of support, this can be a good option.
Lifetime annuities can pay a fixed amount, or can adjust to inflation. It’s important to read and understand the contract you’re signing very carefully, and be sure you’re clear on what will happen when the time comes to collect your income.
Lifetime annuities can be more expensive, and they may have limits on how much can be left to your descendants through annuity payments, but if you expect to live a long time and you’re the sort of person who wants to support themselves in a modest way for the foreseeable future, this may be the way to go about it.
Although annuities are unlikely in the long term to provide the same amount of income as would stocks and bonds, an annuities package is more secure against sudden drastic changes in the markets. For people who don’t want to concern themselves with managing money in old age, a lifetime annuity solves that dilemma.
Fixed Term Annuities
Not unlike a regular investment portfolio: a fixed annuity is essentially a managed investment fund. If you have a large lump sum available, such as the money from selling a house, or even money inherited from a relative, you can buy an annuity that will pay a fixed amount over 10, 20, or even up to 40 years.
Unlike a lifetime annuity, the fixed annuity will stop paying at the end of its maturity, and the principle (the amount of money left after adding up the gains in the investment portfolio, minus the amount you took out), will be returned to you, usually as a pre-agreed lump sum, but sometimes as whatever principle still remains.
Where a lifetime annuity functions more like a gamble from the annuity provider that the recipient will not live long enough to cost the annuity fund more than they put in, a fixed-term annuity fund is generally less risky for the provider, and thus may end up being cheaper. Also unlike some lifetime annuities, which may not pay out to any heirs or remaining spouses or children, a fixed-term annuity usually does.
A fixed-term annuity is useful for someone who, for example, has a certain number of years before their pension or social security coverage begins, and has a large lump sum available that they’d like to keep safe while guaranteeing a stream of income, either for early retirement, or just as a supplement. Those who have trouble managing their money, or are just concerned about the potential for losing money on any risky investments, will find annuities generally much more attractive for their conservative nature.
Enhanced Annuities
If a lifetime annuity is a hedge against a long and healthy life, then an enhanced annuity is sort of life insurance against a long and less than healthy one.
Enhanced annuities are those that will pay out extra if you happen to develop certain covered diseases or disabilities, including stroke, diabetes, multiple schlerosis, heart disease, high cholesterol or high blood pressure. Usually combined with a thorough physical evaluation and many questions from the provider, an enhanced annuity is a bet on your long term health. If you turn out to be very healthy, you lose the bet. Poor you! But if you happen to develop one of the covered diseases, then your payout is increased, which may help you with the additional expenses that can be incurred because of your illness.
Like long-term care insurance or active life insurance, an enhanced annuity is a bet that you won’t be healthy forever. For those who feel uncertain about their future health, or are conservative by nature, an enhanced annuity may provide some sense of financial security even in the case of ill health.
Advantages Of Annuities
The specific advantages of annuities in the state or country where you live may vary greatly. However, some of the standard advantages of annuities are:
- The possibility of tax advantages for purchasing annuities with retirement savings
- The possibility of inflation-adjusted payouts
- The possibility of “enhancements” for disability or illness
- The possibility of lifelong coverage in case you live beyond your expected life span.
Disadvantages of Annuities
Again, the specific disadvantages of annuity programs will vary depending on where you live, but these are always some issues to consider no matter where you are:
- Annuities may or may not be able to be passed on to your heirs or children
- Annuities may not pay out as much as traditional investments such as stocks and bonds
- Annuities might not be inflation-proof, or may cost more for inflation adjustments
- Annuities might not be allowed to be liquidated early, depending on the agreement you pick.
Is an Annuity Right for Me?
Do you have or expect to receive a large amount of money either near or even after your own retirement? Are you a conservative, risk averse type, who wants to know that their future is secure no matter what happens? Then annuities may well be the right choice for you.
It’s worth noting that while we’ve been talking about large annuities, there are often plans that accomodate smaller budgets, and some investors choose annuities that pay out only a small part of their total future income, either as a supplement to their continued working, or to social security or other retirement benefits. Annuities may not be the most profitable choice for many people, but for those who don’t want to worry about the instability of the markets or the economy, and want a guaranteed income over a long period of time, annuities are definitely worth a look.
