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Fixed Lifetime Annuities and Fees

I frequently write about reducing your investment-related expenses (fund expenses, brokerage commissions, etc.) as a great way to improve your expected returns.

I also write frequently about the usefulness of fixed lifetime annuities–they’re a (mostly) safe way to increase the amount you can spend from your portfolio per year.

So it’s no surprise that many readers ask questions about the fees involved in fixed lifetime annuities. For example:

  • When comparison shopping between annuity providers, how can I determine the amount of fees bundled into a given annuity?
  • Isn’t the insurance company just investing my money, taking a cut, and paying me what’s left? Shouldn’t I cut out the middleman and invest the money myself?

Don’t Bother Looking at Expenses

The answer to question #1 is easy: Don’t bother.

When selecting mutual funds, it’s important to look at expense ratios because they’re an excellent predictor of fund performance. (Lower-cost funds tend to outperform higher-cost funds.)

When selecting a fixed annuity, however, you have access to a much better predictor: the payout the insurance company promises.

In this regard, it’s much like buying an individual bond from a corporation. Rather than spending time analyzing the various expenses the company has or trying to figure out what the company will do with the money you loan them, you’d probably pay more attention to:

  • The bond’s interest rate, and
  • The credit rating of the company.

Ditto for fixed annuities. Rather than trying to reverse-engineer an annuity to determine the level of expenses baked in, I’d suggest comparison shopping on the basis of:

  • The payout each annuity provider promises, and
  • The credit rating of each annuity provider.

Important note: The above discussion does not apply to variable annuities. Variable annuities are much more like mutual funds in that it’s important to pay attention to the expenses of the underlying investments.

Should I Cut Out the Middleman?

The second question–whether an insurance company is just a middleman that can be removed in order to improve returns–is somewhat trickier.

The answer is that, yes, the annuity provider is a middleman–they’re investing annuitants’ money, taking a cut, and paying the remainder back to the annuitants.

But there’s more to it than that. The insurance company isn’t just paying each person a fraction of his/her own returns. The insurance company actually redistributes money between annuitants. Specifically, annuitants who live longer than average end up getting to spend the money of annuitants who lived shorter than average.

This redistribution is what makes annuities such a useful tool for minimizing the risk of outliving your money. And, by definition, it’s a feature that you cannot replicate on your own.

So while the insurance company most certainly is taking a cut, that doesn’t necessarily mean it’s beneficial for you to “cut out the middleman” in this case. In general, the decision comes down to the size of your portfolio relative to your expected expenses in retirement.

  • If your portfolio is large enough that you’re not at risk of running out of money in retirement, then you don’t have much need for an annuity.
  • However, if your portfolio is of a size that running out of money is a serious concern, it’s probably a good idea to consider annuitizing a portion of your portfolio.

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Comments

  1. >This redistribution is what makes annuities such a useful tool for >minimizing the risk of outliving your money. And, by definition, it’s a >feature that you cannot replicate on your own.

    I wonder just how much of the $ is redistributed to the insurance companies instead of the annuitants? If it were a significant % then it seems like there would be a real value for a do it yourselves option.

    I agree you can’t do it on your own, but why couldn’t say Vanguard make an annuity fund for lack of a better name. You can buy shares but never sell them all new shares must be bought from the issuing company. They pay out dividends to all living members based on the income of the funds and are invested in a relatively conservative blend of index funds to minimize volatility. When shareholders die the fund increases the payouts to the survivors.

    Is there any such investment?

    -Rick Francis

  2. Michael: LOVED this post & here were the 2 bits that most struck me. These benefits are huge & as someone who worked a buyside analyst & portfolio manager for 15 years… I can tell you that it’s very easy from the outside to under-estimate the huge benefit of risk sharing inherent in this product. Thanks for putting it in such straight forward language…

    (1) “But there’s more to it than that. The insurance company isn’t just paying each person a fraction of his/her own returns. The insurance company actually redistributes money between annuitants. Specifically, annuitants who live longer than average end up getting to spend the money of annuitants who lived shorter than average.”

    (2) “This redistribution is what makes annuities such a useful tool for minimizing the risk of outliving your money. And, by definition, it’s a feature that you cannot replicate on your own.”

  3. Rick: That would be neat. (Also, I believe that’s kinda-sorta-ish what Vanguard’s variable annuities try to achieve.)

    Manisha: Good to hear you enjoyed the article. Your feedback is always valued. :)

  4. I think you are missing that there is a reassigning of risk. When you take your fixed lifetime annuity it doesn’t matter what the market does. So while you can “do it yourself” if you fail you are screwed while the annuity purchaser may not be…as long as the insurance company stays in business lol

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