Are Annuities A Good Alternative for Retirement?

The thought of receiving guaranteed income for life when you retire likely sounds appealing. Pensions are on the decline and Social Security payments may not be enough to cover all your expenses in retirement. This may be why some investors who wish to secure their retirement income are attracted to annuities. But despite their touted benefits, annuities are likely not the best option to reach your goals. Annuities have disadvantages, pitfalls and complexities that may not be easy to see.

About Annuities

With an annuity, the intent is generally to help insure against longevity risk by providing a monthly income benefit in retirement to help prevent a retiree from running out of money.

Whether you choose an annuity that allows you to defer your payments (deferred annuities) or annuitize them right away (immediate annuities) and convert them into periodic payments, the direct and indirect costs of that guaranteed income may surprise you.

First, if you treat your annuity as an investment and don’t annuitize it, the fees you pay can significantly hinder longer-term growth. Deferred annuities offer various optional benefits called “riders.” Riders usually offer enhancements to your annuity contract, such as guaranteed lifetime income, benefits for your spouse or beneficiary, inflation benefits and more. They often help insure against “longevity risk,” or the chance you will outlive your life expectancy. But these additional benefits are expensive—increasing variable annuities’ cost to as much as 3.44% per year[i]—which can easily eat away at your contract’s value.

Second, if you annuitize your contract for income, as in the case of an immediate annuity, the principal is no longer yours. It belongs to the insurance company. In other words, you may be entitled to a guaranteed payment stream, but upon your passing, the ending value of your annuity will amount to zero. This stands in stark contrast to the value of investments in stocks, bonds and mutual funds which you retain control of throughout your lifetime and can pass on to your heirs. If you purchased a variable annuity, you aren’t guaranteed a minimum return on your contract’s value. Instead, you may be entitled to a percentage of returns on products held within your annuity.

Third, most income payments won’t keep pace with inflation. You can add an inflation rider to offset this factor, but this means you receive lower payments initially in exchange for increased income payments later. Also, every optional benefit you add comes with additional fees.

Annuity Alternatives

Is there a less complex and cheaper way to get the benefits of annuities without being subject to their pitfalls? Investors may be better off selecting other investment strategies to generate cash flow from their portfolio.

The first step would be to define your financial goals by asking a few questions:

  • What do you want your investments to provide? Growth? Cash flow? Some combination?
  • How much will your retirement cost, as you envision it? Will you need cash flow to support a spouse, family members or others?
  • What sources of income will you have outside of your investments?
  • Are you interested in leaving a legacy at the end of your life?

Next, define your investment time horizon, or how long you need your money to last. Time horizon is a major determinant of retirement costs and, in our experience, retirees often miscalculate it. People are living longer these days. If you believe your time horizon is defined by your life expectancy, it might be wise to plan for a longer time horizon than a shorter one. Also, your investment time horizon is longer than your life expectancy if you want to leave money to others after you pass.

Finally, determine the best asset allocation for your goals. There is no magic formula for the right asset allocation for you, but often, if you have a longer investment time horizon and less need for cash flow, your asset allocation should generally be weighted toward owning stocks. If you have a shorter investment time horizon and greater cash flow needs, you might choose to invest in bonds to dampen short-term volatility—although a investing a portion in stocks may still be appropriate depending on your circumstances.

Difference Between Income and Cash Flow

Earlier in this article, we brought up the idea of generating “cash flow” from an investment portfolio. We also discussed alternative ways of generating “income” other than through annuities. In case this isn’t obvious, there is a key distinction between the two terms, though “cash flow” has a broader meaning.

Bear the following points in mind:

  • Income is money received, while cash flow is money withdrawn.
  • Bond interest payments and cash dividends from stocks are considered income and taxed accordingly. If this money is withdrawn from the portfolio, it is considered cash flow.
  • Selling a security also generates cash flow. The difference between what you put in and what you take out is reportable on your tax return as a capital gain or loss, depending on the tax treatment of the account from which you withdraw.

Ultimately, whether you pay for your retirement through income or cash flow doesn’t make a big difference. You should be concerned with your portfolio’s total return and after-tax cash flow, not whether your retirement money comes from income received or securities sold. Hence, the term “cash flow” can refer to both—money received or withdrawn.

Options for Generating Cash Flow

We believe the most important factor to determine your portfolio returns and likelihood you can afford the retirement you envision is asset allocation. Through proper asset allocation, you can find ways to generate cash flow from your portfolio while keeping consistent with your longer-term goals. The following are four ways to generate cash flow:

Bonds: Bonds are loans issued by companies, municipalities or countries looking to raise capital. As an investor, you are lending the borrower (usually a company or government entity) money to receive periodic interest payments, at a predefined rate, for a specified period of time. If all goes as planned, the borrower repays the entire principal you invested when the bond matures. You could also sell the bond on the open market before it matures.

Dividends: A cash dividend is a percentage of profits a company distributes to its shareholders, often with the intention of providing it on a regular basis. As an income-based incentive, cash dividends make the prospect of investing in a given stock more attractive. However, there is a caveat: As companies can increase their dividend payments to reward or attract investors, they can also reduce or cancel their dividend payments. Future dividends are never guaranteed.

Homegrown dividends: The strategy of selectively selling stocks on an incremental basis for cash flow is what we call “homegrown dividends.” While investors can incur trading commissions through this strategy, it is a flexible way to generate cash flow that can help you maintain an appropriate investment mix for your goals.  

Cash: Historically cash performs relatively well during a market decline, but holding a big chunk of your portfolio in cash can hold your returns back if you require growth. Unless you believe you have identified a bear market and are shifting to a temporary defensive positioning—a change that we believe should be rare, as it introduces significant risk to your goals—your cash position should be small enough to not hinder your portfolio’s overall growth potential.

Discover Your Investment Options

If you are worried about outliving your retirement savings, know there are several investment alternatives available to you. To learn more about them, read our Definitive Guide to Retirement Income today.

If have questions or need professional assistance on income alternatives for retirement, contact Fisher Investments.

*The contents of this document should not be construed as tax advice. Please contact your tax professional.

[i] Includes annual average annuity fees of 1.21%, variable annuity mutual fund annual fee of 0.63%, and Guaranteed Lifetime Withdrawal Benefit rider fee of 1.6%. Sources: Insured Retirement Institute, 2016 IRI Fact Book (Washington, DC: IRI, 2016), 114; Investment Company Institute, 2017 ICI Fact Book,, 89; Insured Retirement Institute, 2016 IRI Fact Book (Washington, DC: IRI, 2016), 102.

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