Should you use an annuity to cover your basic retirement expenses?
As polarizing as annuities can be, you would think they are part of religious dogma. That’s too bad, because they’re simply tools. Like any tool, they have a proper use and an improper use.
The people who insist every retiree needs an annuity and the people who insist all annuities are garbage have the same problem. They’ve let their beliefs about the tool replace any consideration of the person using it. That’s a dumb way to make a decision you may have to live with for 30 years.
An annuity can make sense when it covers a specific gap in your retirement income.
Knowing you have a monthly payment for bills that Social Security and your pension don’t cover can provide peace of mind. But “peace of mind” is a lousy justification for a purchase if nobody has explained its costs and restrictions. Before using part of your savings to purchase that income, understand which expenses the payments will cover, what access you’ll retain to the money you commit, and whether your remaining savings will be enough for unexpected expenses.
Give the annuity a job
Start with the expenses that keep showing up whether the market cooperates or not. Housing, groceries, insurance, utilities, and healthcare. Then look at how much of that spending your Social Security and pension income already cover.
For an illustration, take a Wichita couple whose basic expenses total $5,600 a month. Social Security and a pension provide $4,400 after taxes and deductions. Their savings need to supply the remaining $1,200 a month, or $14,400 a year.
That gives us a specific gap to evaluate. We can compare buying enough annuity income to cover some or all of it with taking withdrawals from their investments. Either way, we need to account for taxes and the money left available for expenses outside those monthly bills.
Now consider a couple whose Social Security and pension already cover their basic expenses. They may have other reasons to want an annuity, but covering the grocery bill is a problem they’ve already solved. Buying more predictable income deserves a better explanation than “the market might go down.”
Know which annuity you’re talking about
For this discussion, I’m focusing on a fixed income annuity with lifetime payments. You use a lump sum to buy scheduled payments from an insurance company. Those payments can continue for the rest of your life, subject to the insurer’s ability to meet its obligations.
Other annuities accumulate money for later, involve investment choices, or offer optional income benefits. Costs and restrictions vary substantially. A broad opinion about “annuities” tells you very little about the contract sitting in front of you. Investor.gov explains the differences and the limits of insurer guarantees.
The appeal of lifetime income is straightforward. You transfer some of the risk of outliving your money to an insurance company. In exchange, you accept the contract’s pricing and restrictions, including limits on access to the money used to purchase it.
Your grocery store hasn’t guaranteed its prices
A fixed annuity payment promises a dollar amount. Your grocery store has made no corresponding promise.
Suppose our illustrative couple buys an annuity that supplies their $1,200 monthly gap after taxes, and that amount stays unchanged. At an assumed 3% annual inflation rate, the payment would buy roughly $664 worth of today’s goods and services in 20 years. That’s an illustration, not a prediction. But it shows why covering the bills at 65 doesn’t automatically mean covering them at 85.
Some income annuities offer scheduled payment increases. Those increases come at a cost, such as a lower starting payment for the same purchase price, and may not match the price increases you experience. Fidelity describes these payment options.
A predictable paycheck still needs a plan for rising expenses, including inflation.
The money you keep matters as much as the income you buy
With many income annuities, the purchase is largely irreversible after the cancellation period. Some contracts allow limited access to money, but you generally can’t treat the original lump sum like a bank account anymore. That makes the amount you commit a serious decision.
A leaking roof won’t politely wait until you’ve saved enough from your monthly payments to replace it. Neither will a major medical bill. If buying the annuity leaves you short of accessible savings, you’ve traded one source of anxiety for another.
Your spouse also gets a vote. A payment based only on your lifetime may stop when you die. Options that continue income for a spouse or provide benefits to heirs generally reduce the starting payment for the same purchase price. Comparing the largest monthly checks without comparing those protections can lead you to buy the wrong contract. Schwab explains income annuity restrictions and survivor options.
Be honest about what would help you spend
Those restrictions deserve careful attention. So does the benefit of having income you feel comfortable spending. Retirement income planning involves a lot of psychology, and you can have enough money on paper while still feeling sick every time you transfer some of it into checking. After decades of saving, spending can feel like breaking a rule you’ve spent your whole adult life following.
For that person, predictable income covering the basics may be worth paying for. It may make the remaining investments easier to live with during a bad market. Dismissing that benefit because a spreadsheet projects more wealth without an annuity ignores the person who has to use the plan.
But fear also makes a persuasive sales pitch. If someone recommended an annuity to me before understanding my spending, existing income, and need for accessible money, I’d keep my checkbook closed. The recommendation wouldn’t have earned my trust yet.
I would evaluate an annuity alongside your portfolio withdrawals, Social Security claiming choices, and the financial implications when either spouse dies. Buying income for part of your spending can be reasonable. Committing too much of your savings can leave you regretting a decision that looked comforting when you signed.
Before you buy that peace of mind, can you name exactly what you’re getting, what you’re giving up, and which worry will still be there afterward?
This article is for educational purposes and is not personalized financial advice. Annuity decisions depend on your circumstances and the specific contract.
