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.
I there another way to access the Morningstar articles? “Access denied” — even for those with Morningstar Premium access.
Find a library with a Morningstar subscription — many have that, and access it through their online subscription. If you do have premium access, you can access it by searching for the article in their articles section.
David, I agree with most everything you wrote. I am wondering if a retail investor has any alternative way to hedge longevity risk? That seems to be the one (only) reason for buying (some not all) annuity en lieu of bonds.
Is there a better way to hedge longevity risk?
If tontines became legal once more, that would be another way to do it. Though Social Security will get cut by 25% 11 years, that also is a hedge. The last way is investing in equities when the market is reasonably valued… even though you are still subject to the macro risks — government defaults, wars, plague, etc.
Social security will be eliminated for at least 75% of the population. You can bicker over the exact definition, but if social security is eliminated or if social security is “paid” but immediately seized to pay Medicare premiums — the recipient is in the same position. Social security will be eliminated in a decade, it’s just a question of what cover story they use. It was never funded, it was always a Ponzi scheme, and the only thing worse than a Ponzi scheme is one operated by politicians. Both parties have raided social security at whim, with Lyndon Johnson the worst (but from the only) offender.
If you know any upper middle class retirees, than you know congress is already stealing social security payments to fund Medicare. It’s already happening, and each year a bigger and bigger percentage of social security recipients fall into this scheme.
It’s very deceptive to claim social security is being paid when big chunks are already being seized to fund Medicare.
Social security is quickly becoming a purely welfare scheme, and passionate arguments that “we paid into the system” are ignorance. It’s pay as you go, there is nothing to pay into. It’s a scheme backed by the full faith and credit of lying politicians. They can renege anytime, and they are already means testing.
It’s foolish to count on social security unless you are in the bottom 20-25% of income, and if you are in that group then you aren’t reading David’s blog.
Interesting about tontines…. Weird that some financial scams resulted in better regulations, while others were banned outright. Just one more reason not to trust politicians. They allow lottery tickets and gambling, they require participation in Ponzi schemes like social security, but they prohibit actual solutions.
A diversified basket of stocks seems like the best solution available, although I would be terrified of an S&P500 fund, because that’s basically a FANGMAN fund with residuals invested in the other 490 companies — a slight exaggeration, but point remains exposure is very concentrated.
Thank you for your thoughts on longevity risk