The last few weeks I have been writing about the more conventional form of life insurance that most people are familiar with when I say ‘life insurance’ – which is protection against a premature death.
The other life insurance is that which protects your from living too long – and that insurance is the annuity.
Over the years annuities have gotten a bad rap – and rightfully so. Like life insurance, annuities are generally sold to the public via a sales force of licensed agents. In most cases, they are not the right vehicle for the individual (I know I am setting the blog up to receive the thunderous rebuttals) but there may be cases where an annuity makes sense. The other reason annuities get a bad rap is because of the pure insurance (longevity) feature that they provide – especially pure life annuities.
A pure life annuity is simply a guaranteed income stream that lasts as long as the person’s life the annuity is based off of – called the annuitant. The downside to this annuity is that once the annuity stream has started (called annuitization); if the annuitant dies, he or she forfeits the money to the insurance company. This is why these annuities pay the most. The annuitant assumes most of the risk. They could make a payment or two and then die.
This concept is not a bad thing. Risk pooling as it is officially called is the concept of many individuals sharing in the risk of their given pool. The same concept is found in auto and home insurance. Most of us will go our entire lives without making a claim for our home burning down, but we are part of the pool that insures those people whose homes do burn down. Likewise with annuity risk pools. Those who die early pay for those who live too long.
A similar comparison can be made with Social Security – arguably a form of an annuity. A single individual could go their entire life paying into the system, retire, and then die after receiving only a few payments.
Folks interested in annuity or yet, folks that are being shown that they should be interested in an annuity need to understand that first and foremost, it’s an insurance product. This isn’t a bad thing, but it needs to be disclosed. Once you have an understanding that it is an insurance product, ask yourself, “What am I insuring?” The answer to this question is your longevity and not running out of money. Another question to ask is “Do I need an annuity right now?” The answer is that it depends on your age and what need regarding income in retirement.
Generally speaking, the younger you are, the less you need an annuity. There are plenty of other tax-favored vehicles (no, not life insurance) to build wealth over time. The older you are – then it depends. If you’re going to be receiving Social Security as well as a pension (another form of annuity) then I would argue no, as part of your retirement is already insurance against you living too long via Social Security and the pension.
Over the next few weeks I’ll explain the pro and cons of annuities. I’ll dive into expenses, add-ons (called riders), and different forms of annuities to be aware of and beware. I’ll also explain when it is generally unwise to buy an annuity and when it may make sense.