In the arsenal of retirement planning tools, annuities are among the most expensive - but that does not necessarily make them the best. Entering into an annuity contract at the wrong time can be costly. A period of “financial repression,” for example, renders annuities ineffective and unattractive.
Financial repression describes measures by which a government channels funds to itself as a form of debt reduction. Main characteristics include large government debt, interest rates capped or indirectly held down by the government, government ownership or control of domestic banks and financial institutions, and the creation or maintenance of a captive domestic market for government debt.
Such an environment benefits a debtor government in several ways. First, holding interest rates low keeps the cost of issuing and holding large debt cheap. Government ownership of, or increased government control over, banks and financial institutions allows the government to create a market for its debt. The government can require banks to hold a certain level of reserves that will be invested in safe government debt. Extended periods of low interest rates can also result in inflation, another boon to debtors, since the relative cost of their debt decreases when currency’s purchasing power erodes.
Does this sound familiar? The Federal Reserve is holding long-term interest rates at historic lows. Congress continues to bicker about raising the debt ceiling. The government has imposed new restrictions on the banking and finance industries through Dodd-Frank.
The government has taken these steps to pull the U.S. economy out of recession. The debt funds stimulus programs to create jobs for the unemployed. The low interest rates are meant to encourage companies and individuals to borrow and spend, bolstering the whole economy. Banking and securities regulation boosts confidence and greases vital financial gears that had ground to a halt.
Theoretically, these are good. Yet together, they can be characterized as financial repression, of which the gravest results are low interest rates and an increased risk of inflation. Such an environment is tricky for savers, because they earn less in interest income and their future purchasing power erodes.
This climate of low interest rates and the threat of inflation makes annuities unattractive for those saving for retirement.
Let’s start with the most basic annuity — a fixed, immediate annuity. A saver pays a lump sum to the annuity provider, an insurance company, and receives an income stream that begins immediately. The insurer assumes that the initial investment will earn a certain percentage based on the current low-risk interest rate. From this, the insurer calculates the size of the periodic payments, structured so that the initial premium is exhausted at the end of the saver’s life expectancy. With low interest rates, the insurer does not anticipate that the money will grow much over time, which leads to low payout amounts for the annuitant. Below is a chart depicting the monthly payout amounts for an annuity with a $100,000 start value and a 15-year expected payout period at various interest rates.
|Net Annual Interest Rate||Monthly Payment|
A fixed, deferred annuity adds another layer of complexity, as the initial premium is allowed to grow for a certain period before the payout begins. Deferred annuities offer a guaranteed interest rate for at least the first part of the accumulation phase. The guaranteed rate is determined by the current interest rate. After the guarantee period is up, the rate resets annually. This is a great feature when rates are high and the annuitant can lock in significant earnings each year. However, locking in 1 to 2 percent growth per year is not very appealing.
Inflation is the next hurdle for this sort of annuity. Low interest rates become negative relative to actual interest rates when inflation is included. That is, when you lock in a low guaranteed interest rate on an annuity, you are in effect ensuring that you lose purchasing power, and are paying dearly for the privilege. Your monthly payout 10 or 15 years down the road will not buy as much as it would have at the beginning. If you intend to rely on annuity income to pay expenses later in life without considering inflation, you may find yourself short.
You generally have the option to purchase some sort of inflation protection with your annuity, which will increase the payout amount over time. However, this option is not without cost. Also note that if the inflation amount assumed by the annuity is less than actual inflation, you still lose purchasing power, if not quite as much.
Variable annuities are the better option in an environment of financial repression. With a variable annuity, you can choose to invest your nest egg in a portfolio of equities and fixed-income securities instead of earning the guaranteed interest rate. Equities will offer some insulation from inflation, since they are also affected by inflationary price increases. But variable annuities are more risky than the fixed variety because the returns fluctuate with those of the underlying portfolios and can be negative. The reason an annuity appeals to most purchasers in the first place is the certainty of an income stream. When you buy a variable annuity, that certainty is diminished.
If you are considering investing in an annuity, patience is your highest virtue. Interest rates will not always be this low. Eventually, they will rise and bring higher growth and payout rates for annuities. Jumping into a contract now will not be easy to undo when things start to change. Fees for leaving an annuity prematurely are generally prohibitive in the early years of the contract, making it financially painful to switch to a new annuity. Waiting until interest rates are closer to a historically average level is the wise course.