An annuity is first and foremost a stream of payments. For most retirees, the payor is an insurance company. Properly regulated, an insurer can “guarantee” the payments it promises; in fact, if an insurer gets into trouble, annuitants in payout status are considered senior creditors, i.e., they get paid first—even before the rent.
Annuities can pay for a specified number of years or for a lifetime or two, which given today’s extended life expectancies, can be open-ended. Today’s extended life expectancies gives actuarial science enhanced economic value when it comes to providing a return on investment: an annuity can yield more from the get-go if average life expectancy is assumed while the longer an annuitant lives, the more payments received, the greater the IRR. So annuities are best purchased by people expecting to live into their nineties– or even beyond—who don’t want to worry about running out of money no matter how long they survive.
In a traditional fixed annuity, the insurer invests in mostly investment-grade fixed income instruments to match its assets to its liabilities. Based on its projected earnings (usually reflecting the yield on the US ten-year Treasury) and its projected expenses, it shares the blended yield on its portfolio holdings with the annuitant, paying a fixed return for the guaranteed duration. The purchasing power of that fixed return will be eroded over time by inflation, which is a key drawback to this structure. The payout, however, remains unvarying, unless you buy an inflation “rider” which increases it year to year based on some measure, but inflation riders tend to be expensive and depress the initial payout level.
A variable annuity also offers an income that will never run out, but the insurer invests the policy-owner’s premium in equities. The objective is to generate a higher level of income over time, but the income payout is subject to market risk and can either increase or decrease from year to year. The potential to decrease—possibly requiring “belt-tightening” and a reduced lifestyle that can end up being permanent—is the biggest drawback to this structure. A poor sequence of market returns can end up undermining the income floor most annuities are intended to provide.
The fixed index annuity is a relatively new hybrid. Like a fixed annuity, it guarantees an income floor from inception. But unlike a traditional fixed, its earnings are linked to one or more market indices and those earnings can be applied to the annual income payout to establish a higher floor from year to year. If markets are favorable, the annuity income can increase and those increases are rendered permanent; unlike a variable annuity, the income yield doesn’t suffer even if markets have a bad year or two.
The older an annuitant, the higher the initial payout of any income annuity. So the traditional fixed can be very advantageous for retirees in their 80s. They should shop for the highest payouts being offered by the better-rated companies and consider a portfolio approach. The deferred fixed index annuity lends itself well to investors approaching or just entering retirement, say between ages 55 and 75, aspiring to give inflation a run for its money over the long term without taking a hit on the initial payout once begun and risking income reductions if markets decline.