This argument isn't unique to annuities, of course. Morningstar director of personal finance Christine Benz points out that there are plenty of other ways to balance income-generating investments for living expenses with equities using a bucket strategy
. And research
by financial-planning experts Michael Kitces and Wade Pfau also demonstrates that a rising equity glide path doesn't have to be tied specifically to an annuity.
The choice really boils down to a debate over the flexibility of straightforward fixed-income investments versus the higher potential return of an annuity generated by mortality credits. (Premiums paid by those who die earlier than expected boost the growth of the insurance company's overall risk pool, providing higher yield to those who live longer; the credits increase significantly with age.)
Kitces and Pfau found that the mortality credits really only materially help those who outlive their own life expectancy. SPIAs underperformed fixed-income and equity portfolios during very short time frames, and over the intermediate term, the annuity also underperformed a portfolio with an equivalent rising equity glide path but that used fixed-income investments rather than an annuity. (Several interesting papers
have been published recently challenging the traditional wisdom that exposure to equities should fall with age. Kitces and Pfau have done some of this work; another analysis comes from Rob Arnott
, CEO of Research Affiliates.)
6. What About Inflation?
Several Morningstar commenters on January's column
worried about inflation's corrosive effects on the value of annuity payouts over time. Some income annuities can be purchased with inflation protection that boosts payments either by a set percentage annually or at a rate tied to the consumer price index. (With DIAs, the inflation protection begins at the time payments begin.) But the protection is costly, Tomlinson says. "You could buy an annuity with inflation protection, or just invest other assets in stocks or a commodity-based asset that provides that protection."
Specifically, Tomlinson suggests measuring the market's expectation for inflation against the cost of inflation protection in the annuity. (You can get the market expectation for inflation by comparing yields
on a Treasury Inflation Protection Security with a conventional Treasury bond with the same maturity date.)
"If the market expects 2% inflation, I can get a quote for a SPIA with a 2% annual step-up and compare the price for that with what I would have to pay to receive the same initial income from an inflation-adjusted annuity," he says. "That will tell me how much of a markup there is for the protection from the risk of higher-than-expected inflation."
Vernon acknowledges the risk that inflation can erode the value of an annuity with a fixed payment. But he thinks annuities also offer an inherent protection against rising prices because they offer higher levels of income at the start of retirement than a traditional drawdown plan. "I'd argue more money is better if inflation is high," he says.
7. How Does My Spouse Factor In?
Married couples should approach annuity purchases as they would Social Security-claiming
decisions--that is, buy protection with a surviving spouse in mind. Joint-and-survivor coverage can be purchased with varying percentages payable to the survivor--50%, two thirds, and 100% are popular choices. Initial payments while both spouses are alive will be lower than for single-life annuities, but it does provide valuable additional protection.
"I always lean toward protecting the spouse," Tomlinson says. "Don't assume you will die and your wife will marry some rich guy immediately. I run into many situations where people have come up short in providing for their spouse."
Spousal protection also underscores one of the virtues of an income annuity, says Vernon. "They're very user-friendly as you get older; the check comes in the mail or via electronic funds transfer," he says. "As people get older and less able to manage finances, that's a real plus--especially if you have a surviving spouse who typically hasn't been in charge of handling the family finances.
"I don't mean to sound sexist, but that usually is the wife, so having a monthly check come in without having to lift a finger is a very good thing. As a man, having a joint-and-survivor policy gives me the comfort of knowing my wife will be taken care of after I'm gone."
Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living. The views expressed in this article do not necessarily reflect the views of Morningstar.com