A friend of mine recently asked me if I thought annuities were a good investment idea. For context, her key concern was market volatility which is why she was looking at annuities.
I’m not a big fan of annuities but I decided to ask an artificial intelligence to tell me what the pros and cons of annuities are and here is what I got:
Annuities are financial products designed to provide a steady income stream, typically used for retirement planning. Here are some pros and cons:
Pros of Annuities:
- Guaranteed Income: The primary benefit is the guarantee of a steady income stream for a specified period or for life, which can be a significant advantage for retirees.
- Tax Deferral: Earnings from annuities grow tax-deferred until withdrawal, which can be beneficial for long-term growth.
- Protection Against Market Fluctuations: Some annuities offer protection against market downturns, ensuring the principal investment is not affected by market volatility.
- Customization and Riders: Annuities often come with options (riders) for additional protection, like death benefits for beneficiaries or long-term care coverage.
- Estate Planning: Certain annuities can be structured to pass wealth to heirs, potentially avoiding probate.
Cons of Annuities:
- Complexity and Fees: Annuities can be complex financial instruments with various fees and charges, such as administrative fees, mortality and expense risk charges, and surrender charges.
- Lower Return Potential: Compared to direct investments in stocks or bonds, annuities might offer lower return potential due to their conservative nature and fees.
- Inflation Risk: Fixed annuities may not keep pace with inflation, leading to a decrease in purchasing power over time.
- Lack of Liquidity: Annuities often impose surrender charges for early withdrawal, making them less liquid compared to other investments.
- Interest Rate Sensitivity: The value and attractiveness of certain annuities can be sensitive to changes in interest rates.
It’s essential to thoroughly understand your financial needs, risk tolerance, and the specific terms and conditions of the annuity product before making a decision. Consulting a financial advisor is often advisable when considering annuities.
The Pros seem pretty good to me as it’s guaranteed income and protection against market fluctuations but the Cons seem very concerning with inflation risk (we’re going through that now, fees/charges, lack of liquidity, and interest rate sensitivity. Given all we’ve been through since the pandemic with inflation, interest rates and market volatility, I don’t think annuities are a good choice.
I told my friend to consider creating a diversified bond portfolio which will mimic the guaranteed income part of an annuity and can also protect against market fluctuations if the portfolio is diversified properly. The fees for buying bonds from the Treasury or through the broker are often low or mostly zero. By diversifying bonds into inflation protection, time span (2, 5, 7, 10, 20 yr) and tax free municipals and others the same results can be achieved while retaining liquidation and avoiding fees from annuity brokers.
Ultimately, however, if my friend doesn’t want to bother with buying her own bonds and building a diversification strategy then she may as well buy the annuity. I know people that mow their own lawns but I don’t do it because I don’t want to deal with all the equipment, heat, cleaning, and disposal of yard waste. To each their own but I think learning to diversify bond portfolios is far more important than mowing lawns.
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