In retirement planning, the choice is often between buying an annuity and maintaining a diversified investment portfolio. Both can provide you with retirement income, but one can offer you peace of mind in a way the other can’t, and they will differ in cost, flexibility, transparency, and long-term growth potential.
Costs and Fees
Many annuities (particularly the variable annuities) have a number of fees attached to them: insurance fees, investment expenses and optional income guarantees. All of these can significantly impact your long-term return.
A portfolio consisting of a range of low cost ETFs, stocks and bonds can often be managed at a lower cost than other types of portfolio and that in turn allows you to keep more of your returns.
Access to Your Money
One big benefit of a traditional investment portfolio is liquidity. You can generally get at your assets without any surrender penalties (though of course selling an investment will probably trigger capital gains or losses).
Annuities will often have surrender charges if you withdraw your money early (these can last for several years). Some income annuities will in fact require you to give up access to your principal in return for the guaranteed payments.
Growth Potential
Annuities will often have growth limitations in return for the insurance guarantees. Fixed indexed annuities are a case in point, with their caps, participation rates, and spreads all serving to limit returns.
A diversified portfolio lets investors gain more direct exposure to market growth, receive dividends and interest, and adjust their investments as market conditions evolve. Of course, market losses are still possible.
Retirement Income
Annuities can provide guaranteed lifetime income (which may be of some comfort to the retiree who is worried about outliving their savings).
A diversified portfolio can also provide retirement income via interest, dividends and planned withdrawals. The alternative to the annuity’s contractual guarantee of income for life is, of course, that your portfolio withdrawals will depend on the performance of the portfolio and the amount of assets available.
Flexibility and Control
With a diversified portfolio, you can tweak the allocations, change your strategy or get access to the funds as your circumstances change.
Annuities are generally quite inflexible. The surrender provisions, the income benefit rules and all the other restrictions can make it very difficult and expensive to make any changes.
Managing Investment Risk
A very common reason people buy an annuity is to protect themselves against market loss. You can also manage risk through diversification, fixed income, hedged equities and options overlays.
These approaches may help to reduce volatility and drawdowns whilst preserving liquidity; they won’t eliminate market risk and won’t in any way replicate the insurer’s lifetime income guarantee.
The Bottom Line
Annuities can be a good fit for an investor who is very much in favor of guaranteed lifetime income. The problem is that this guarantee often comes at a price (higher cost), with reduced liquidity and growth potential.
For many retirees a properly diversified investment portfolio is a far more transparent, flexible and cost effective way of managing their retirement funds.
The objective should not simply be to ensure income, but to build a retirement strategy that accounts for income, growth, risk, and access.