Can Annuities Act Like a Pension?

The guaranteed income of annuities is labelled a hero by some and a money trap by others. What’s the real story?

We have to preface this article with a simple reminder: there is no one miracle product that can address every need you have. There are upsides and downsides to every investment option. But few are as misunderstood as annuities.

The Upside

Annuities are probably the closest thing to a defined benefit pension plan that you can get. They offer guaranteed income for the rest of your life. That’s pretty much exactly what most people are looking for in retirement.

Let’s say you’re a 65-year-old male (annuity prices are based on age and gender), and need an income of $1000/month. You’d need to purchase an annuity of $171,726 to guarantee this income for the rest of your life – no matter how long you live, and no matter how the markets are performing. In comparison, that same amount stashed under your mattress would only last about 14 years.

But the cost of that $1000/month annuity goes down as you age. If you purchased it at age 75, it would only cost you $124,649. That’s because the number of years you will likely withdraw a monthly income will have decreased substantially. In this case, if you put the money under your mattress and took out $1000 each month, you’d run out in ten years. But with the annuity, you are covered for life.

The Downside

So why do annuities get such a bad rap?

First, the money deposited to your annuity is inaccessible during your lifetime. Let’s say you needed to deal with a large medical bill, you could not access the money in the annuity. Even though that’s also the case with a defined benefit pension plan, it can be tough to swallow. It’s also a good reason to have a separate sum of money for emergencies.

Second, many people believe the money invested in an annuity is not accessible to your spouse or family when you die. The truth is many annuities provide a cash refund option that allows you to assign any unused portions of your annuity to your beneficiaries after your death.

Third, some annuities don’t keep up with inflation. If you consider that you may be retired for 30 years, inflation can take a big bite out a fixed annuity income. However, you have the option with most annuities to receive an income that is indexed to inflation, albeit at a higher cost.

The Bottom Line

The bottom line is that annuities address the very real risk of running out of money in retirement. But they aren’t a silver bullet. When you understand their benefits and shortcomings, you can develop a strategic plan to potentially integrate them into your retirement.