The Morningstar Gamma research cites Annuity Allocation as one of the five ways to increase retirement income. They assume 25% allocation to a fixed annuity with a payout rate of 5.71%.
What’s the catch?
The most important thing to note is that a payout rate is far different from a rate of return. The payout rate is only achieved if you live a very long time. Premature death 10-15 years into annuity payments will yield a negative return on your investment.
The following chart illustrates how the annuity will yield a negative return in the first several years after purchase and approach the payout rate over time.
Notice that if we assume purchasing the annuity at age 65, the rate of return does not turn positive until after age 80.
What is an annuity?
Purchasing a fixed annuity is essentially buying insurance against living too long and it is important to note that it works very similarly to other forms of insurance.
Your money is pooled with funds from other annuitants and those who live a very long time benefit from the lifetime income stream while those who die early lose much of their investment.
Since the greatest financial risk for retirees is running out of money, this is a popular strategy and can be worthwhile depending on the rest of your financial situation and how long you expect to live.
However, the factors described above, the costs associated with annuities, as well as other factors often make them unattractive.
Our two cents…
In our view, this illustrates that the use of an annuity is less definitive in retirement planning than the other strategies and needs to be analyzed in the context of each client specific situation rather than accepted as appropriate in all cases.
But financial planning isn’t “one-size-fits-all.” Before any major decisions, be sure to consult a financial planner who can advise you on the best course of action based on your personal situation.