Do Annuities Make Sense for Your Retirement Plan?

I’m finally in the home stretch.

After four and a half decades, I’m perhaps two to three years from becoming “work optional” and downshifting my career from full-time to half-time or less.

At that point, besides writing online, I’ll only work when I find an interesting project that lets me work with people I like, with compensation a far second consideration (if even that).

Of course, if the recent market turmoil continues, I may choose to put off “pulling the trigger” on this change for a little longer.

My (Financial) Concerns Around “the ‘R’ Word”

This brings up the question – how do we optimize the following three things:

1. The likelihood of not running out of money, even if we live into the three-digit age bracket
2. The amount we can spend in retirement
3. The predictability of our retirement income

This reminds me of former NASA Administrator Daniel Gordin, who coined the motto “Cheaper, Better, Faster,” which led to many NASA people jokingly adding “… pick any two.” I later privately added, “… and you may get it.”

The problem is, if you want to increase the likelihood you won’t run out of money, you need to reduce your spending or accept higher volatility in your annual budgets.

Alternatively, to spend more in retirement, you need to accept a higher risk of running out or higher budget volatility.

Finally, increasing predictability typically requires giving up higher returns, which means you need to spend less or accept a higher likelihood of running out of money.

An Interesting Option – Annuities

Annuities have a long and mostly well-deserved negative reputation as needlessly complicated and expensive products, sporting high fees to pay enough to get agents to sell them to clients.

However, chosen carefully and used the right way, some annuities can boost your retirement finances – enter Morningstar’s State of Retirement Income report.

Along with delaying Social Security retirement benefits and flexible portfolio spending strategies, Morningstar looked at annuities as a tool to lift lifetime retirement income, “… an allocation to a simple immediate or deferred annuity can … help enlarge in-retirement cash flows. But … allocation to the annuity early in retirement reduces the money in the portfolio that can compound over the retiree’s drawdown period.”

How Annuities Can Help with a Static Draw Strategy

For a plan based on total returns from an investment portfolio (i.e., not limited to dividends), especially with a static strategy like the so-called “4 percent rule,” safe withdrawal amounts are calculated to help the portfolio survive a worst-case scenario. More accurately, if you’re looking for a 90 percent chance of success (i.e., not running out of money), the withdrawals have to be such that no more than the 10 percent worst simulated runs lead to failure.

As a result, you will almost certainly draw less than your portfolio could actually support. Annuities, on the other hand, pay more than this (10 percent) worst-case scenario allows for, letting you (a) spend more, (b) improve your likelihood of retirement success, or (c) a combination of those two.

Of course, there’s a downside to this – your portfolio will be smaller, at least during the early portion of your retirement, likely resulting in a smaller remaining balance when you die.

Morningstar’s analysis showed that buying an immediate annuity at age 67 with 10 percent of your portfolio balance increases your initial annual draw (relative to a static 3.7 percent draw plus Social Security benefits assumed to allow a $73k initial draw) by $1k to $74k.

Increasing the fraction of your portfolio used to buy the annuity to 20 percent adds $2k for that first year (relative to the baseline), while using 50 percent of the portfolio adds $3k.

If you were to buy an 18-year-deferred annuity at age 67 with 10 percent of your portfolio and retire at age 67, you’d add $6k to the baseline, bringing it to $79k. Upping the fraction used for the annuity to 20 percent adds $11k to the baseline.

How Annuities Can Help with a Dynamic Draw Strategy

If you opt instead to go with a dynamic strategy (e.g., the so-called Guardrails Approach) that allows a higher safe initial withdrawal rate, covering more of your expenses by annuity income means that when a market crash forces you to cut spending, that cut will apply to a smaller portion of your retirement income, making it less painful.

How Do You Use Annuities?

What’s Appropriate for Retirees?

Let’s start with a more straightforward question: What type(s) of annuities may be appropriate for retirees?

Morningstar states, “Annuity contracts sold by insurance companies come in many forms. The most appropriate annuity version for retirees seeking guaranteed income consists either of 1) immediate lifetime annuities, which distribute monthly payouts for the remainder of the retiree’s life or some predetermined period, starting when they are purchased; or 2) deferred annuities, which begin their payments at a specified later date.”

What About Inflation?

The next question we should ask is: Do annuity payments keep up with inflation, as do Social Security benefits?

The simple answer is: Not really.

The more accurate answer is that the base version of annuities pays out a constant payment in nominal dollars, so over a 30-year retirement, the purchasing power will decline by nearly 60 percent (assuming a 3 percent average annual inflation rate). 

However, you can often purchase an inflation rider that increases your payout in nominal dollars by, e.g., 3 percent each year. The problem is that this rider decreases your initial payments (for example, an immediate annuity purchased by a 67-year-old may lose nearly a quarter of the initial payment size).

The following graph compares the cumulative payments from the two flavors of immediate annuity. In red, we see the standard case, where the payouts are the same each year, so the cumulative total increases in a straight line. 

The other type, in green, however, starts with a lower annual payment, but increases it by 3 percent each year. As we can see, the break-even point is after 20 years. If the recipient survives longer than 20 years beyond the annuity starting point, they will come out ahead, in nominal dollar terms. If they die sooner, they’d have come out behind.

The second graph, below, is the same, except that here we assume an annual inflation rate of 3 percent, and compare real (i.e., inflation-adjusted) cumulative payments. With this, the break-even point moves further to the right, to 22 years.

How likely is a 67-year-old retiree to survive beyond age 89?

According to the Social Security Administration’s actuarial table, it’s about 24 percent (i.e., less than one chance in four) for a man and 36 percent (i.e., a little more than one chance in three) for a woman.

But what if inflation runs hotter, say 5 percent a year?

As we see in the third and final graph, both lines curve to the right, showing a gradual decrease in purchasing power. The difference is that the red line shows a 5 percent annual decrease while the green line shows a more gradual decline of about 2 percent annually. 

Here, the break-even point moves even further to the right, to 24 years!

With this change, the likelihood of a man surviving to age 91 and coming out ahead with the 3 percent annual increase rider drops to one in six, while for a woman, the odds are about 27 percent, a bit better than one in four.

Given those figures, and the fact that retiree spending tends to trend down by as much as 2 percent a year, it may be a better bet to stick with the standard version and have more money to spend when you’re more likely to need it.

How Do Annuities Compare to Social Security Retirement Benefits?

This makes annuities a distant second to Social Security benefits for two reasons. First, Social Security gives cost-of-living adjustments (COLAs), and these COLAs are determined by increases in the Consumer Price Index (CPI), even if that’s double digits, vs. annuity insurance riders that are for a set annual percentage increase. If inflation is tamer than that rate, you win. If inflation runs hotter, you lose.

Second, while Social Security benefits are backed by the full faith and credit of the US federal government (and no matter your political persuasion or views on the US national debt, that’s still considered near-zero risk), annuity payments are backed solely by the insurance company’s financial stability.

What Are the Main Types of Fixed Annuities?

The two main types of fixed annuities are so-called single-premium immediate (typically called single-premium immediate annuities) and deferred annuities. 

As the names suggest, the former starts paying out as soon as you give a lump sum of money to the insurance company, while the latter lets the insurance company invest the money you give them during the deferment period. 

The insurance company’s expectation of positive investment returns allows it to increase your payout from deferred annuities relative to immediate ones for the same premium. The longer the deferment, the greater the increase in payouts. 

However, inflation will eat away at the value of those higher payouts during that deferment (as well as after). In addition, there is the opportunity cost of not being able to invest the money yourself, with potentially a higher return than the insurer’s guaranteed increase. Thus, you’re giving up the possibility of a higher inflation-adjusted payout from investing the money for the period you’d have deferred the annuity, which would allow you to then buy an immediate annuity with the larger sum of money you’d have, in return for the (likely smaller but) guaranteed increase.

What Else Do You Need to Decide?

Another matter is the type of payout you want. If the insurer stops paying as soon as you die (a.k.a, single life), they’ll pay you more each year than if you have them keep paying until both you and your spouse die (a.k.a, joint life). Also, not that you can do much about it one way or the other, but (all other things being equal) men typically receive a higher payout than women, because women have longer life expectancies, so the insurer assumes it’ll have to pay longer. 

What Are the Typical Results of Using Annuities with Part of Your Portfolio?

Along with Social Security, annuity payments (though the latter, as discussed above, will gradually lose purchasing power due to inflation) aren’t subject to the stock market or to market interest rates. This means you have a larger “floor” of retirement income to cover as much as you can of your fixed costs.

Since annuity payouts tend to be higher than you’d expect to draw from a portfolio, you’ll be able to spend more in retirement. However, once you (or you and your spouse) die, the insurer keeps the remaining money (if any), so your bequest is smaller.

Morningstar research shows that a retiree can increase their spending by buying an annuity with part of their portfolio’s value. However, they’d need to spend a big chunk of their portfolio to see a significant increase.

For example, someone claiming Social Security benefits at age 67 and having a $1 million portfolio could expect to spend about $2.19 million over a 30-year retirement and have $1.33 million left over (but recall that these dollars would be worth 30 years’ worth of inflation less).

If they’d spend 10 percent of their portfolio’s value on an annuity (Morningstar assumed they’d buy the 3 percent annual inflation rider), they’d get an extra $1k a year or $30k over a 30-year retirement. As a result, their balance after 30 years would be (on average) $1.17 million. This means they’d be buying a total of $30k with $160k worth of remaining balance to bequeath to their heirs (or charity).

Increasing the fraction of the portfolio used to buy the annuity to 50 percent increases annual payments by $3k and the 30-year retirement total by $90k. However, the remaining balance shrinks by $600k to a mere $730k! 

How about buying a deferred annuity?

Morningstar shows that with similar assumptions, a 10-year-deferred annuity purchased with 10 percent of portfolio value would increase annual payouts by $5k and total 30-year payouts by $150k. However, this would reduce the ending balance, on average, by $270k. Deferring by 18 years (the maximum age allowed at payment start is 85, which is 18 years after the assumed age of 67 when the annuity is purchased) increases the total payout by $180k but reduces the ending balance by $300k. 

Obviously, doing the same with 20 percent of your portfolio would lead to a higher total spend, but decrease the ending balance by even more. However, the likelihood of living from age 67 to age 85 or more, so you get to enjoy the higher payouts from an 18-year deferred annuity, is 40 percent for men and 54 percent for women.

Given all this, why would you even consider an annuity?

Simple. It reduces your risk of market losses gutting your portfolio, especially if the market crashes early in your retirement. This is because the larger fixed income you get from Social Security, plus the annuity, reduces how much you need to draw from your portfolio by more than the fraction of the portfolio value used to buy the annuity, so you’d be selling fewer shares when the market is down.

How Annuities Can Work as Part of a Holistic Plan

Optimizing your retirement finances can be complicated. Some questions you’ll need to answer for yourself (perhaps with the help of a financial advisor) include these:

• What does your ideal retirement budget look like? How much of that is non-discretionary (think mortgage payments, utilities, car payments, groceries, etc.) vs. discretionary (e.g., travel, gifts to family, charity, etc.)?
• What are your big goals? Do you want to leave a large bequest to heirs and/or charity? Want to take a luxury trip around the world? Maybe undertake a large upgrade to your home?
• How much of your non-discretionary expenses do you want to (or are able to) cover from non-portfolio income sources, e.g., rental income, Social Security, annuities (this is where these fit in), pension (if you’re exceptionally lucky), part-time work, etc.?

There is an interplay between many of these decisions.

For example, if you want to have more non-portfolio income, you’ll need to pay for a larger annuity, which reduces your portfolio size. This limits your long-term growth potential but decreases the volatility of your income stream.

If your priority is money available for spending and/or gifting while alive, you might buy a larger annuity and use a dynamic withdrawal strategy such as the Guardrails Approach. The larger annuity makes your portfolio smaller. However, that’s offset by the higher safe initial withdrawal with the dynamic strategy. The downside is that this would make your eventual bequest much smaller, but that’s less of a concern if your priority is lifetime spending and gifting.

If your priority is to leave as large a bequest as possible, you’d try to minimize how much of your budget is non-discretionary. This can be done, e.g., by downsizing and/or moving to a lower-cost-of-living area, paying off your mortgage and car loans, completing any major home upgrades while still working, etc.

Next, you’d delay Social Security as long as possible while still working (possibly part-time) to avoid draining your portfolio too much.

Finally, you’d consider the tradeoff between the larger percentage of income you’d get from an annuity relative to a fixed safe withdrawal, vs. the impact of reducing your portfolio size to cover the annuity premium, trying to optimize for the largest likely portfolio ending balance.

Mike Hunsberger, Owner, Next Mission Financial Planning, shares his take on annuities, saying, “I encourage clients to make sure they have secure income (pension, Social Security, annuity income) that will cover their essential expenses. These are things like housing, healthcare, and food that they will have for their entire life. This is the way you can make a promise to your older self that you will never run out of money for the basics. My preferred annuity vehicle is the single premium immediate annuity to generate this needed income. It’s simple, and typically there aren’t many fees or moving parts a retiree needs to worry about.”

Joshua Mangoubi, Founder and Wealth Manager at Considerate Capital, offers some nuance, “Annuities serve as protection against the financial risks that come with outliving your savings. High-net-worth (HNW) people typically don’t need insurance against longevity because their amassed wealth can support them throughout an extended retirement period without needing annuity funds. People with small savings who lack pension benefits can find a timely Single-Premium Immediate Annuity (SPIA) to act as a financial backup by delivering dependable income support during retirement. Still, it’s not something to rush into. Try to maintain flexibility before you decide to allocate a large sum of money to a product that doesn’t allow for simple reversal.”

Stephen Mazer, Principal, Senior Wealth Advisor at Rational Wealth Solutions, agrees, “Our industry, too often, only promotes the idea that over time, market returns will provide the basis for retirement income. Guaranteed income in retirement is what I believe allows retired clients to peacefully sleep at night. We work with our clients to see if an annuity adds value to their long-term retirement income plan. Whether the goal is highest income, possible Long Term Care (LTC) income boost, or another annuity benefit, there are a multitude of annuity alternatives to consider for many retirees and pre-retirees. Sufficient guaranteed income could come from Social Security and/or a well-funded pension for some. For others, it could additionally come from a reliable income stream of rental properties or dividend-paying stocks. Annuities are THE opportunity for many people to create their own private pension guaranteed income that does not require the client’s active involvement (think repairs or reviewing quarterly dividend announcements) to keep flowing.

Omar Morillo, Founder of Imperio Wealth Advisors, elaborates, “Annuities can play a strategic role in retirement planning when used thoughtfully, particularly to cover essential, non-negotiable expenses like housing, food, and insurance. I often recommend them as part of a ‘guardrails’ approach: using guaranteed income sources to fund baseline living costs while allowing investment portfolios to support discretionary spending, such as travel or lifestyle upgrades. This structure helps retirees maintain confidence that their core needs are met regardless of market volatility. 

“The type of annuities I typically recommend are deferred Registered Index-Linked Annuities (RILAs). These contracts offer a blend of market participation with downside protection and can provide lifetime income benefits. For retirees concerned about longevity risk and inflation, certain RILAs can also provide opportunities for income growth over time, and many can be structured to support both spouses over their lifetimes. 

“That said, I advise caution with high-cost or opaque annuity products. Not all annuities are created equal; some come with complex riders or steep internal charges that can diminish their value. Transparency, cost, and the financial strength of the issuing insurer are critical when evaluating these options. As for how much of a client’s portfolio to allocate to an annuity, it’s driven by their essential spending needs. We work backward from their required monthly income (adjusted for inflation) to determine the present-day funding necessary. The goal isn’t to replace the entire portfolio with annuities but to strategically de-risk the portion needed to secure basic living expenses. For clients who value predictability and peace of mind, a well-structured annuity can be a powerful complement to a diversified investment strategy.”

The Bottom Line

Between Social Security (and when to claim benefits, and how much of your retirement budget benefits will cover), rental properties, stocks (and do those pay out dividends or not), bonds, cash, maybe a pension, and now annuities (and deciding whether to buy an immediate one, deferred, or both…), not to mention your desired retirement budget, the fraction that’s fixed vs. discretionary… it can be a lot.

Given the enormous complexity and sheer number of moving pieces, hiring the right advisor, at least for crafting your initial financial plan for retirement, may be your best investment.

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.