Morningstar - Q4 2021 - 12

Dispatches
How to Use Annuities
in Retirement
And what to consider
when holding bonds.
IVORY TOWERS
John Rekenthaler
In this issue's Spotlight, and in a larger white
paper,1
Social Security disbursements, this contract
does not adjust for inflation. If the annuity's first
monthly check is $382, then so are all future
checks. (Although some do offer cost-ofliving
increases, most of this type of annuity
make nominal payments.)
Morningstar's Jasmin Sethi tackles
the question of whether retirees should
have access to more annuities. She responds yes,
but with an asterisk. Sethi has little use for
complex products, such as fixed index and variable
annuities. Rather, she favors the most basic
varieties: single-premium immediate annuities,
which begin their payments shortly after
they are purchased, and the deferred versions of
the same annuities, where the investor buys
the annuity today, but the benefits arrive later.
As Sethi points out, annuities face both legal
and practical challenges. Their sales are governed
by a hodgepodge of regulations, primarily from
state laws and the SEC, but with additional
rules from the Department of Labor if they're used
in IRAs or 401(k)s. Adding to the confusion is
the industry's lack of standardization. Annuity
features, and how they're described and reported,
vary by provider. There are no nutrition labels
for annuities.
Because Sethi thoroughly covers those problems,
I will skip the barriers that annuities face
and discuss instead how they might fit into a
retiree's portfolio.
The Simplest Version
Let's evaluate the simplest version of the simplest
offering: a single-premium immediate annuity,
which will promptly yield a fixed monthly benefit
guaranteed for the buyer's lifetime. Unlike
Our test case is that of a freshly minted retiree,
born 65 years ago, who holds $100,000 in
a balanced fund. The fund suited her nicely while
she was employed, but it carries two drawbacks
for her current situation. First, it yields only
1.4%, and she seeks higher income. Second, its
price fluctuates. Because our retiree no longer
earns a salary and thus cannot work her
way out of investment trouble, she seeks greater
investment safety.
She is therefore considering two possible
acquisitions: a 30-year bond or a single-premium
immediate annuity. If she chooses the bond,
she will buy it directly, spend the income,
and recoup the principal when the bond matures.
With the annuity, she will hand over her
money to the insurer and obtain a stream of
ongoing payments in exchange. In either case,
her credit risk is negligible, as both the bond's
and the annuity's insurers are rated AAA.
Top-rated corporate bonds yield about 2.79%,
thereby providing an annual income of
$2,790. Annuity rates are considerably higher. As
a single woman, our retiree can earn 5.09%, or
$5,090 per year. That amount rises to $5,270
for men-live hard, die young!-and drops to
$4,750 for married couples. In all cases, the
annuity yields far more income than the bond.
Bonds Versus Immediate Annuities
(30 Years, $100,000 Investment)
Type
AAA Bonds
Annuity (Single Men)
Annuity (Single Women)
Joint Annuity
Annual
Payment ($)
2,790
5,270
5,090
4,750
Legacy ($)
100,000
Sources: Federal Reserve Bank of St. Louis, Blueprint Income.
A Better Comparison
This exercise, of course, is unfair to bonds. As
the final column of the chart indicates, there is a
huge difference between owning a bond
and holding an annuity contract. The former is an
asset, the latter a promise. When the retiree dies,
her bond continues to exist, becoming part of her
legacy. In contrast, the annuity vanishes.
However, our retiree needn't put everything
into the annuity. She could use part of her
balanced fund to buy a single-premium immediate
annuity and put the remaining money into stocks.
Then, she could spend the annuity proceeds
and let the equity ride. Eventually, that stock
position might outgrow the bond's principal. If so,
the retiree would score a double victory:
higher income from the annuity/stock blend than
would have been possible from the bond and a
better legacy, as well.
Addressing the various possibilities of time horizon,
equity weighting, and stock market returns is
beyond the scope of this column, but an example
provides the essential idea. If the retiree placed
80% of her assets into the annuity, 20% into
equities, and survived the next 30 years, she would
not only have received $1,430 more income
per year than if she had bought the bond, she also
would have increased her estate, assuming that
stocks gained more than 5.51% per year.
Bonds Versus Annuities/Stocks
(30 Years, $100,000 Investment, Female)
Annual
Portfolio
100% Bonds
80% Annuity/
20% Stocks
If Stocks
Return (%)
NA
2
4
5.5
6
8
10
Payment ($)
2,790
4,220
4,220
4,220
4,220
4,220
4,220
4,220
Sources: Federal Reserve Bank of St. Louis, Blueprint Income,
author's calculations.
Legacy ($)
100,000
20,000
36,000
65,000
100,000
115,000
201,000
349,000
1 Sethi, J. 2021. " Should We Have More Annuities? " Morningstar White Paper, July. https://www.morningstar.com/lp/annuities-in-retirement
12
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