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Volatility driving retirees to think longevity annuity

Retirees, and those nearing retirement, just can't seem to catch a break these days.

For years now, they've been saddled with paltry interest rates on high-quality bonds and savings products, and today's uncertain economic outlook has the Federal Reserve rethinking the timing of further rate hikes.

Couple signing documents with financial advisor
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What's more, the stock market has been a hot mess for much of 2016, further stoking fears among many older Americans that they might someday fall short of their spending needs in retirement.

"It used to be that older investors could build fairly conservative portfolios and be confident that they would hit their retirement spending goals, but that is much more difficult today," said Jared Kizer, chief investment officer of Buckingham Asset Management and The BAM Alliance, thanks to interest rates being at historical lows.

The solution for some investors facing the prospect of running short of money during retirement might lie in an often misunderstood and somewhat maligned class of insurance products called annuities.

An annuity is essentially a contract with an insurance company that is funded by the buyer and designed to generate an income stream during retirement.

Like old-fashioned defined-benefit pension plans, some annuities guarantee buyers lifetime income — which might not only help retirees sleep better at night but also keep them from drawing down their portfolios too quickly or during a market rout, as well as allocating too little to stocks.

Another selling point of annuities is that buyers pay no taxes on the income and/or investment gains on their contributions until they begin receiving payouts.

Yet buying an annuity isn't a step to be taken lightly. For one thing, annuities — which come in multiple varieties — can be complex, and similar products may vary greatly in terms of what they offer and what they cost.

As with any investment, don't buy what you don't understand, experts say. It's important for buyers to shop around and make sure they understand the return structure, benefits and fees for any contract they are mulling.

Annuities are sold by insurers and also offered through brokerage firms, banks, low-fee mutual fund companies and online comparison-shopping sites, such as Hueler Investment Services' Income Solutions platform.

"There are some providers that offer lower-cost versions of variable annuities, but in general the marketplace has a lot of high-expense products that aren't in people's best interest to use." -Jared Kizer, chief investment officer of Buckingham Asset Management and The BAM Alliance

Another thing to consider with regard to annuities is the fact that they aren't guaranteed by the Federal Deposit Insurance Corp. (FDIC) or any other federal agency.

That means prospective buyers should also check on the financial stability of contract-issuing insurers. One source of information is A.M. Best, an independent rating agency focused on the insurance industry.

"It's rare for an insurance company to fail, but you can't completely discount the issue," Kizer said.

There are two broad categories of annuities: immediate annuities and deferred annuities.

With immediate annuities, buyers typically hand over a lump sum and begin receiving payments right away. The most common type pay a fixed income that is based partly on how much a buyer contributes to an account, the age and gender of a buyer and the term of a given contract, which may be one lifetime or two (in the case of spouses or partners).

With deferred annuities, investors contribute to their accounts over time or through lump-sum payments and begin receiving income at some future date, such as when they turn 85.

The income stream from deferred annuities — which are relatively new and haven't gained much traction among consumers — tends to be notably higher than the income stream from immediate annuities, according to Anthony Webb, research director for the Retirement Equity Lab at the New School's Schwartz Center for Economic Policy Analysis.

Not surprisingly, many consumers are loath to part with a chunk of their savings to insure against the possibility of outliving their assets at some future date.

"People have difficulty understanding that living a long while in retirement can be a bad outcome" from a financial perspective, Webb said. "They think of buying an annuity as a risky gamble that the household will lose if [you] die relatively young."

According to Kizer, a longevity annuity — a type of deferred annuity that offers a guaranteed regular payout once buyers reach a certain age — can be a good retirement-planning tool for some investors.

"You certainly wouldn't do this with all of your portfolio — maybe just 10 percent — but these can be a great tool if bought from a good insurance company with good pricing," he said.

Of course, buying a longevity annuity doesn't make much sense for those who don't expect to live a long time in retirement because of poor health or their family medical history, added Kizer. In fact, insurance companies profit from annuities by spreading risk among many buyers, some of whom will live a very long life and some of whom will die shortly after they buy an annuity.

One of the largest and most controversial segments of the annuities world is the variable-annuities market. Variable annuities allow buyers to allocate their contributions among different investment options, such as mutual funds, stocks and/or accounts with a guaranteed minimum rate of return.

Some variable annuities (i.e. immediate variable annuities) begin generating an income stream right away, while others allow buyers to defer payouts.

The return on variable annuities is, as their moniker implies, variable. In other words, it's tied to the performance of underlying investment accounts.

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One of the knocks against variable annuities is that the advisors, brokers and insurance agents who sell them often pocket fat commissions. In addition, the fees associated with these products, which include expenses associated with underlying investment accounts, can be high, dragging down returns and account values. Some variable annuities levy annual fees as high as 2.5 percent.

There may also be other costs, including so-called surrender charges, which are a type of sales charge for withdrawing money from an account during a set period of time after purchasing a contract, typically six to eight years.

"There are some providers that offer lower-cost versions of variable annuities, but in general the marketplace has a lot of high-expense products that aren't in people's best interest to use," Kizer said.

Mark Cortazzo, a senior partner at Macro Consulting Group, says many of the variable annuities sold before the financial crisis were actually a pretty good deal for consumers because insurers had to "throw in the kitchen sink" to overcome the stigma surrounding these products.

For a flat fee of $299, his firm's Annuity Review service will analyze up to two existing variable annuity contracts, providing clients with reports on contract structures, benefits and fees, among other information.

"There are plenty of examples of variable annuities that aren't a good deal, but that does not mean that they as a class are not useful or good," said Cortazzo, who is a certified financial planner.

— By Anna Robaton, special to CNBC.com