Annuities Aren't What They Used to Be

Ruth Saldanha: Annuities are insurance products where you pay a life insurance company a lump sum amount and then get fixed monthly income for life. Some investors are worried that annuity payments are headed lower and they may have missed the chance to get a good payout. But is this really the case? David Blanchett, Morningstar Investment Management's Head of Retirement Research, is here today to talk about this.

David, thank you so much for being here today.

David Blanchett: Thanks for having me.

Saldanha: First, for our viewers who may not be familiar with annuities, what are they?

Blanchett: So, annuities have been around for thousands of years, okay? They are one of the oldest insurance products that exist. And you mentioned it – it's effectively a trade. So, you've got a pot of money and you can use that pot of money to figure out how much income you can take from it every year in retirement, you can invest it or you can just say, you know what, I'm going to give it to you, the insurance company, and you send me a check as long as I'm alive. So, in some sense, they kind of radically simplify the income process in retirement.

Saldanha: One of the things that has been worrying investors up here in Canada is that the prices and the annuity payouts are headed lower. So, have investors missed the bus with annuities right now and why are payouts headed lower?

Blanchett: Sure, they've definitely gone down. Annuity payments are based upon two key factors. One is, how long you're going to live for. So, if you're going to live for a long time, the payments are going to be smaller. But then, also, like what is the rate of return that the insurance company can earn on the monies that you give them as the premium. So, what's really important is, it's true that the payments have gone down for annuities. But here is the thing. If you do it yourself, it's also gone down as well. And this is really counterintuitive, but annuities are actually more valuable the lower interest rates are, right? And I'll explain why.

So, again, there's two key pieces about how you figure out payouts for annuities. Like, there's the mortality piece and the investment piece. Well, let's just say that interest rates today are zero, they are not but they are close, okay? The mortality piece is why annuities can create more income for retirees. Because the idea is that you're kind of pulling your risk together in that if you pass away early, it subsidizes someone that lives for a long time. And so, it is true that today you're going to get a lower payout than you would have, say, six months or a year ago, but they also now create more income compared to investing the money yourself in a portfolio of bonds. So, definitely, lower rates but actually more attractive relatively speaking.

Saldanha: You mentioned that annuity payments are lower in a low interest rate environment. What are some of the other risks to keep in mind with annuities?

Blanchett: So, I mean, an annuity is a guarantee that the insurance company is guaranteeing for life. And there's different guarantees that back that up. In the U.S., there's state guaranty associations. But at the end of the day, you want to make sure that the company that you're giving your money to is going to be able to make those payments for life. And so, you don't always want to just initially buy the annuity with the highest payout. You need to think about the insurance company's kind of overall financial strength because it is a lifetime guarantee that could last 30 or 40 years.

Saldanha: Are there any circumstances in which annuity payments might head higher and if so, what are they?

Blanchett: Sure. So, one example is COVID. So, if people start dying earlier than expected, in theory, annuity payments are going to go up. The problem though is that with the uncertainty in the market we didn't really see that. The other part of the equation is interest rates, if they rise, they will go up as well. So, again, the things that have brought them down, especially interest rates, could also bring them back up if markets improve and interest rates head higher.

Saldanha: Finally, as an investor how should I decide which annuity would work for me? How do I pick?

Blanchett: So, it's really complicated. I think the first question you have to ask yourself is should I annuitize at all? Do I want to buy an annuity? And I think that there's a few things to think about there like how long am I going to live. Another really important thing is how did – if I'm a retiree, how did the recent volatility make me feel. And what I mean by that is it's really hard to know how much you can spend from a portfolio in retirement that could last 25 or 30 years, and annuities make it much easier. People love to spend income; they hate to spend down assets. And so, if you are someone that is going to worry a lot about is my portfolio going to last, how much should I withdraw, annuities can radically simplify that process. And so, the simplest annuities are those that you trade money today for income today. So, you trade $100,000 and the insurance company gives you $5,000 a year forever. I think if you are someone that wants more guaranteed income and you like the idea of certainty, you should definitely look into them more.

Saldanha: Thank you so much for being here today, David.

Blanchett: Sure.

Saldanha: For Morningstar, I'm Ruth Saldanha.