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Should you buy an annuity? Before you buy, know the internal rate of return and understand the statistical likelihood of regret. Thumbnail

Should you buy an annuity? Before you buy, know the internal rate of return and understand the statistical likelihood of regret.

There are countless articles written by both cynics and advocates with this exact title. I’d like to be on the record with my own response. 

Annuities are investment products issued by insurance companies that are typically sold to consumers. Rarely are they purchased by investors. While there are exceptions, most annuities are designed to provide the investor with a guaranteed income stream. Along with this income stream are bells and whistles and complex features that make the product sound enticing to investors (and those who sell them). 

Just because annuities are sold, doesn’t mean they’re bad. But the way they’re sold often is bad. Too often, the information used to sell the product doesn’t fairly provide the consumer with the information they need to make an informed decision.

It’s not the information that the salesperson relays to the client that is necessarily bad, it’s the information that’s often left out of the discussion: the internal rate of return. The IRR is the rate of return that is based on a series of cash flows. It’s not a hard calculation for someone who’s studied finance, but the reality is that few advisors care to do the calculation and understand the reality of what it is they’re selling. 

Before buying an annuity, you should ask about the IRR. If the individual recommending this product can’t compute this and help you understand the situation where you'll benefit from the purchase, that’s a bad sign.

What you’ll likely find is that the IRR starts to look attractive well past life expectancy. In other words, if you live a long life, there’s a chance you’ll look back and be content with your decision to purchase that annuity. Until that point, it’s likely going to be an ugly net benefit to you, the investor.

A better strategy almost all the time is to invest reasonably, maintain a conservative withdrawal rate, and keep your costs down. A 4% withdrawal rate is widely considered to be very safe, and unlike the annuity, you’re likely to get pay raises along the way, which will tip the scales strongly in favor of this strategy. 

To help you understand odds of success using this strategy, check out this chart which illustrates the chances of success over varying time horizons across varying degrees of risk:

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There are so many great take-aways from this chart. I like to point out the “risk of not taking risk”. In other words, the most conservative “safe” allocation carries the highest risk of failure.

Based on the above information, I would argue that most modern-day annuities are best suited for the client who is unwilling to take stock market risk in their portfolio. The aversion to market risk comes from a lack of understanding of market risk. This chart helps one understand that taking market risk only increases the chances for success.   

Here are additional negative aspects of annuities that you should also be aware of:

  • Cost: All-in costs often exceed 3%/year. These include contract expenses known as M&E charges, rider expenses and investment expenses.
  • Liquidity: Surrender charges penalize you if you change your mind about the investment.
  • Investment restrictions: These products often force you to invest a certain way, allocating large portions of the portfolio to defensive investments, doubling down on the 'safety' of the product and limiting the potential for upside. Because the annuity already offers downside protection, this is a redundant effort that only hurts the investor’s chances of benefiting from the contract.

So.......should you buy an annuity? At least understand the trade offs of this over alternative strategies. If you have questions about your annuity, don’t hesitate to reach out. I’d love to review your contract with you to help you determine if it makes sense for your situation.

Written by Justin Dering, CFP | Founder, North Country Wealth Management

This is being provided for informational purposes only, and should not be construed as a recommendation to buy or sell any specific securities. The views expressed are those of Justin Dering & North County Wealth Management and do not necessarily reflect the views of Mutual Advisors, LLC or any of its affiliates. Investment advisory services are offered through Mutual Advisors, LLC DBA North County Wealth Management, a SEC registered investment adviser.