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Retirement Planning > Retirement Investing > Annuity Investing

Where Do Annuities Fit in Your Client's Retirement Strategy?

By Roger Wohlner

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What You Need to Know

  • Wade Pfau and Spencer Look discussed some of advisors' annuity concerns at the recent Morningstar conference.
  • The particularities of annuity investment will depend on a client's retirement income style and spending goals.
  • Decisions about annuities should be made in the context of a broader strategy that includes Social Security benefits, stock allocations and bond investments.

Annuities can play a number of roles in your client’s retirement income strategy. However, there is often a degree of confusion among advisors and their clients about if and how to use annuities.

At last week’s Morningstar Investment Conference, annuity experts Wade Pfau and Spencer Look discussed a number of these concerns and offered ideas as to how annuities can fit in as part of a diversified retirement investment portfolio.

The Panel

Aron Szapiro is Morningstar’s head of government affairs and previously served as head of retirement studies and public policy.

Wade Pfau, Ph.D., CFA, RICP, is a leader of the Retirement Income Style Awareness profiling program and has been a longtime professor at The American College of Financial Services and program director of the Retirement Income Certified Professional designation. He holds a doctorate in economics from Princeton.

Spencer Look, FSA, is associate director of retirement studies at Morningstar. He conducts research across many topics but primarily focuses on annuity and life insurance products and lifetime income solutions.

Here are some highlights from the session.

Main Types of Annuity Payouts

Look offered an overview of the two main ways annuities pay out: deferred annuities, which have an account balance, and income (or immediate) annuities. Both types can be utilized to provide a stream of retirement income.

One of the main issues with income annuities, Look noted, is that once the money is annuitized, it can be hard to get that wealth out of the contract.

Deferred annuities also can offer a number of riders for things such as long-term care, guaranteed death benefits and lifetime withdrawals.

Models for Fee-Only Advisors

The discussion moved to annuities geared to fee-only and fee-based advisors. Pfau indicated that annuities have traditionally been commission-based, but he has seen a trend in recent years toward annuities that have stripped the commissions out.

This is more prevalent with deferred annuities with an account balance. Some issuers have created a framework where advisors can charge a fee on the annuity account balance in much the same fashion as the other assets they manage for the client.

Retirement Income Styles and Tradeoffs

Szapiro guided the discussion toward retirement income styles, or strategies, and their accompanying tradeoffs — real or in the client’s mind.

Pfau addressed several things that advisors should consider with their clients. For one, “the idea of a tradeoff between meeting a spending goal versus not being able to provide a legacy” is misguided, he said.

“With the conversation around annuities, it’s important to remember it’s not all or nothing,” he said. “It’s not, ‘Do I put everything in the annuity or do I put everything in investments?’”

Speaking of tradeoffs, Pfau added that investors should think about annuities as a fixed income replacement.

“You’re not necessarily selling stocks with a risk premium to purchase the annuities; you’re trading bonds for annuities,” he explained. “That sort of context really leads this idea that there are different viable strategies out there for how people can approach retirement, whether it’s with a total return investing strategy, a bucketing strategy or a strategy that might fill an income gap.”

For instance, the annuity could be used to build a protected income floor and create a framework for investing toward more discretionary goals.

Selling Bonds to Purchase an Annuity

As noted by Pfau and reiterated by Look, it generally makes more sense for investors to trade bonds for an annuity rather than to liquidate stocks to purchase an annuity.

“If you’re getting an annuity for income purposes, it’s really going to be an effectively fixed income asset class exposure in your overall portfolio,” Look said. “It’s important to recognize that and use a portion of the bond portfolio to buy the annuity and to reflect that in future portfolio rebalancing.”

Pfau added that if an investor is selling stocks to purchase an annuity, they might be sacrificing the opportunity to build a legacy for their heirs. Selling bonds to fund the annuity purchase allows them to keep the overall stock allocation the same for their household balance sheet.

What Academic Studies Say

The panelists also addressed some of the many academic studies on annuities. Look mentioned that a number of these incorporate consumption smoothing, both pre- and post-retirement. Annuities can lead to a smoother income path because they provide more certainty of income.

Deferred annuities with living benefits are complicated financial products, Pfau said, adding that there is a concern that in the midst of that complexity it can be difficult for an investor to tell if the insurance company is taking too big of a cut from the annuity.

There are secondary factors as well, Pfau added. “One of these other factors you see with that total return approach is an accumulation mindset post-retirement. Some people still focus on maximizing returns over having a predictable income, whereas other people change to a distribution mindset, which is they’re more worried about having predictable income over maximizing returns.”

Social Security, Annuities & Inflation

When making decisions about annuities, investors mustn’t forget to factor in Social Security. Delaying Social Security claiming past full retirement age adds 8% per year to the benefit, Look noted, which may help retirees fight inflation better than any annuity.

Pfau added that he views Social Security as longevity insurance and inflation protection for a surviving spouse, with the benefits of the higher-earning spouse lasting for the joint lifetime of the couple.

Fixed Indexed Annuities

The panelists also made several important points about fixed indexed annuities.

Look mentioned a study he was doing that found these products can help mitigate the impact of any portfolio shortfalls over time. Unlike income annuities, which are basically commodity-like products, fixed indexed annuities are really deferred annuities that can offer a number of features to consider for retirees.

Pfau added that income annuities, single premium immediate annuities or deferred income annuities should all offer higher lifetime payouts than a fixed indexed annuity with a living benefit.

In some cases, those with a fixed indexed annuity don’t take full advantage of all of the protections offered by the contract.

Roger Wohlner

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