Retirement researchers are often enthusiastic about annuities, but many consumers are reasonably skeptical. Here to discuss basic information about annuities and their pros and cons is Christine Benz, Morningstar’s director of personal finance and retirement planning.
This interview has been edited for length and clarity.
Q: How do income annuities work, and how they are different from investing in something that pays out income like bonds?
A: An annuity is a contract with an insurance company. In the most basic annuity type, income annuities, you give the insurance company a pool of your money, and they send it back to you as a stream of income over your lifetime. Those types of products give you more income than you could earn by investing in a bond.
They do that because you benefit in the annuity by what’s called “longevity risk pooling,” which means that some people who are buying that same annuity will die sooner, which enlarges the payout for the whole group of you. If you’re the one who lives to be 99, you’re the winner in that situation. That’s one reason that payouts are higher than you’d see for traditional fixed-income instruments. The other big reason is that if you buy an annuity, your money is gone, effectively. You get cash flows, but you can’t get your principal back. In contrast, when you buy a bond, you receive income, but you receive your principal back at the end.
Q: How can these types of annuities help with retirement planning?
A: These very basic income annuities can be helpful in terms of addressing a household’s basic living expenses. Say my household basic expenses—housing, taxes, healthcare—total $40,000, and Social Security is going to give me another $30,000 of that $40,000. I could buy an annuity that will supply me with $10,000 a year to help meet those basic cash flow needs. That’s an elegant use of an annuity, and it can help retirees figure out how much they would want to put into such a product, by examining how much they actually need from it.
Q: Savings annuities, or “deferred annuities,” allow investors to get market exposure in addition to income. What are some key savings annuity types?
A: The most familiar one is a variable annuity where you’re in control of the investment allocations. There are also increasingly popular “fixed index” annuities, where you get market exposure, but there are caps on your gains. There are also caps on your losses. Registered index-linked annuities fall between those two product types on the risk spectrum.
Q: These products are more complicated than income annuities, and they carry more risk and higher costs. How can investors make sure they know what they’re getting into with these products?
