Annuities vs. Market Risk: The Long-Term Retirement Winner?

Understanding the Key Players: Annuities and Market Risk

Before deciding between annuities and market investments, it's essential to understand what each option brings to the table.

What Are Annuities?

Annuities are financial contracts issued by insurance companies designed to provide regular income after retirement. You pay the insurer either a lump sum or a series of payments, and in return, you receive guaranteed payouts after a specified period. There are several types of annuities:

• Fixed Annuities: These provide predictable payments for a set period or for life, offering stability but lower growth potential.
• Variable Annuities: These involve investment sub-accounts that can fluctuate in value, offering higher growth potential but also greater risk.
• Indexed Annuities (FIAs): Linked to stock market indices, they offer some upside potential with built-in protections against losses.
• Immediate Annuities (SPIAs): Payments begin almost immediately after a lump-sum payment.
• Deferred Annuities (DIA/QLAC): Investments grow tax-deferred, with payouts starting later in retirement.

What Is Market Risk?

Market risk refers to the potential for investment losses due to broad market fluctuations. Investing directly in stocks, bonds, mutual funds, or ETFs exposes your portfolio to external factors like economic conditions, interest rates, geopolitical events, and industry performance. Unlike annuities, market investments do not guarantee a fixed payout but offer the potential for higher returns over time.

The Case for Annuities: Security and Predictability as Cornerstones

Annuities are particularly appealing for retirees who prioritize predictability and guaranteed income.

Guaranteed Income for Life

One of the most compelling features of a lifetime annuity is the promise of a steady income stream for as long as you live. This provides peace of mind and ensures that basic needs like housing, food, and healthcare are covered regardless of market conditions.

Longevity Insurance

Many retirees are more concerned about outliving their savings than about dying. A lifetime annuity protects against this "longevity risk," ensuring that payments continue even if you live well into your 90s or beyond.

Tax-Deferred Growth

In deferred annuities, earnings grow tax-deferred until withdrawals begin, allowing for greater accumulation over time.

Psychological Comfort

For many retirees, the certainty of a regular income reduces financial anxiety, especially for those without pension plans who rely solely on their savings.

The Downside of Annuities

Despite their benefits, annuities come with several drawbacks:

• High Fees: Variable annuities often have multiple layers of fees, which can significantly reduce returns.
• Limited Access to Funds: Once money is annuitized, it becomes illiquid, making it difficult to access large sums without penalties.
• Less Inflation Protection: Fixed annuities typically offer static payments that lose purchasing power over time unless inflation riders are included.
• Lower Potential Returns: The guarantees offered by annuities often come at the cost of lower growth compared to market investments.

The Case for Market-Based Investments: Growth and Flexibility as Priorities

For retirees who value capital growth and flexibility, market-based investments may be more suitable.

Higher Long-Term Returns

Historically, the stock market has delivered strong returns over the long term. A diversified portfolio tracking the S&P 500 has averaged around 7-10% annually, outperforming the conservative returns of most annuities.

Liquidity and Flexibility

Unlike annuities, market investments offer liquidity, allowing you to access funds quickly, adjust your portfolio, and pass assets to heirs without restrictions.

Inflation Hedge

Investing in equities can act as a natural hedge against inflation, as companies can raise prices and earnings tend to grow with inflation over time.

The Downside of Market-Based Investments

While market investments offer growth potential, they also come with risks:

• Market Downturns: Portfolio values can drop significantly during market crashes, such as in 2008 or early 2020.
• Sequence-of-Returns Risk: Selling assets during a bear market can lead to permanent losses, especially for retirees withdrawing funds.
• Emotional Fortitude Required: Managing a market portfolio requires discipline and the ability to withstand volatility without making impulsive decisions.

The Long Run: Who Ultimately Wins? A Multifaceted View

The decision between annuities and market investments depends on individual circumstances, including time horizon, risk tolerance, health, and inflation protection needs.

Time Horizon and Compounding

For those decades away from retirement, the market often wins due to compounding and long-term growth. However, as retirement approaches, sequence-of-returns risk becomes more significant, making annuities a valuable safety net.

Risk Tolerance

If market fluctuations cause anxiety, annuities can provide peace of mind. For those comfortable with volatility, market investments may offer better returns.

Health and Longevity

Annuities are most beneficial for those with a long life expectancy. If you expect to live longer than average, an annuity can provide greater long-term value. Conversely, if you have health concerns, your heirs might receive less than the amount paid into the contract.

Inflation Protection

Most fixed annuities do not offer inflation protection, while market investments historically perform better against inflation over extended periods.

Costs and Fees

Market investments, such as index funds and ETFs, generally have lower fees than variable annuities, which can erode returns over time.

The Hybrid Approach: Harnessing the Best of Both Worlds

Combining annuities and market investments can offer the best of both worlds, leveraging their strengths while mitigating weaknesses.

The “Floor and Upside” Strategy

This strategy involves using a portion of retirement savings to purchase an annuity that covers essential expenses, while investing the remainder in the market for growth. This approach helps protect against inflation and market downturns.

The “Bucket Strategy”

This method segments retirement assets based on withdrawal timelines:

• Short-Term Bucket (Years 1-3): Invests in low-risk, liquid assets to cover immediate expenses.
• Medium-Term Bucket (Years 3-10): Allocates to less volatile assets like bonds and fixed annuities for stable returns.
• Long-Term Bucket (Years 10+): Focuses on growth-oriented assets like stocks to benefit from compounding.

By ensuring you don’t have to sell depreciated assets, this strategy balances security and growth.

Conclusion: “Winning” Is Personal

There is no one-size-fits-all solution to retirement planning. Whether annuities or the market wins depends on how you define success. Annuities offer guaranteed income and longevity protection, while the market provides growth potential and flexibility. A hybrid approach can help you achieve a balanced retirement plan that meets your needs and goals.

Ultimately, consulting a fiduciary financial advisor can help you tailor a strategy that aligns with your unique situation.

FAQs

Are annuities always an unwise investment due to high fees?

Not necessarily. While variable annuities can have high fees, fixed annuities and SPIAs usually have lower costs. Annuities are valued for their guaranteed income and longevity protection, so it’s important to weigh the costs against the benefits.

How much of my retirement savings should I allocate to an annuity?

Generally, annuities are used to cover essential living expenses not already covered by Social Security or a pension. Using the “floor and upside” strategy, you can invest the remainder for growth, ensuring your basic needs are met regardless of market performance. This allocation may range from 25 to 50% of your liquid assets.

What is “sequence-of-returns risk,” and why is it important in retirement?

Sequence-of-returns risk occurs when you withdraw funds during a bear market, potentially depleting your portfolio permanently. Many retirees use annuities to cover essential expenses, reducing reliance on market withdrawals in early retirement.

Can an annuity truly protect me from inflation?

Basic fixed annuities typically do not offer inflation protection. Some annuities allow for annual adjustments, but these often come with lower initial payouts. A diversified market portfolio with a strong equity component is generally considered a better long-term inflation hedge.

How can I find a trustworthy financial advisor?

Seek a fee-only fiduciary advisor who is legally obligated to act in your best interest. Organizations like NAPFA and CFP Board can help you find qualified professionals. Interview several advisors to ensure they align with your philosophy and communication style.