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Don't be afraid of buying an annuity: An annuity can be good value if you use it right.

Updated on June 12, 2014
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Cruncher is the pseudonym of an actuary working in London with experience in insurance, pensions and investments.

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Lots of personal finance bloggers don't like annuities. And I can understand why. But I don't agree. If you understand what annuities are for and use them right they can be a very useful addition to your portfolio.

But before I explain why I think annuities can be a valuable and useful of your portfolio, let's look at the reasons some people don't like them.

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Criticisms of annuities

1. Poor value

If you look purely at a return on capital then annuities don't usually do as well as other investments. That's true - but that's because you are paying for the insurance they offer against living too long and running out of money. If you factor that in, the equation might be different.

2. Too complicated

Annuity contracts are often far too complicated with options, investment guarantees and other bells and whistles. I think the industry could do a lot to simplify this and make everyone's lives easier.

But until then, you will have to do it for yourself. Understand what you want to protect against and make sure that your contract does that. And avoid add-ons you don't need or understand. You might find it helpful to speak to a good broker, who can explain what the various terms mean.

3. Not flexible

Annuity contracts are generally fixed for life (one of the reasons it's important to shop around). Which means if your needs change you can't adapt. But if you can afford to keep some of savings for a rainy day, that can give you the flexibility you need. No one is suggesting you put all of your money into annuities.

4. Losing your capital

This I am afraid is the inevitable trade off. If you want the insurance company to pay out more if you live longer, you have to accept that they will pay less if you don't. That's the deal, no way round it.

But there are ways to soften the blow. Many annuities allow you to select a "guarantee period" (at a small price) which means if you die early in the contract your estate will get some of your money back. If you are really concerned about "losing out" because of dying before your time, look into the option of a guarantee to put your mind at rest.

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Investing the rest of your pot

Once you have used annuities to make sure you are financially secure, you can be more relaxed about investing the rest of your portfolio in higher reward (but also higher risk) kinds of investment.

Find out more about investing in:

Equities

Corporate Bonds

Gold

These and other kinds of investment can bring better returns on average over the long term than standard "vanilla" annuities can - but they don't offer you protection against running out of money.

As always make sure that the mix of risk and reward in your portfolio suits your taste and circumstances.

Annuities can be "good value" and an important part of your portfolio, if they are used correctly.

First understand what annuities are. They are insurance. They are not going to make you rich, but they might make sure you don't end up poor.

An annuity basically insures you against running out of money when you are old. If you live longer than expected an annuity that pays out for the rest of your life can really dig you out of a hole.

Remember - there is no such thing as a free lunch when investing. Passing that risk to an insurer comes at a price - remember lower risk comes with lower return. But the sacrifice of a lower return can be worth it, if it means you don't have to worry about living on hand outs in your old age.

Second, don't buy something you don't understand. Many annuity contracts are too complicated. This makes it hard to shop around effectively and very hard to know if you are getting value for your hard earned money. Buy something simple which has a payment structure you understand. You need to know what you are going to get and when in order to make sure the annuity is doing it's job of providing a stable income.

If you do decide to go for a product which includes investment bonuses or other top ups or contingent payments make sure that the base amount (assuming you get no bonuses) is enough for you to live on. Then the bonuses can be extra money to spend on little luxuries. If you are relying on payments which are not guaranteed to make sure you have a decent standard of living you might as well not have bothered buying an annuity at all.


Third, don't rely on annuities alone (if you can afford not to). Assuming you have enough money to provide more than just the basics, you don't need to put it all into annuities. Use annuities to provide a base income that you think will make sure you are comfortable and can survive your old age. Then you are free to invest the rest of your capital in more lucrative assets that will earn you a better return (but won't guarantee to feed you into nineties like an annuity will).

If you are wealthy enough that even if you took a big hit on your investments you still would be more than comfortable, then it's quite possible annuities won't be for you. You won't need that sort of protection - but you should have planned (or paid someone to plan) your investments so that they will offer you some protection in a market crash or crisis.

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And finally

I accept annuities won't be for everyone. And many people are sold annuities that are not right for them at all. But don't let that stop you making annuities work for you.

Annuities can be a really good way of protecting yourself from poverty in old age and everyone should consider making them part of their retirement portfolio. Annuities won't make you rich but they can stop you from being terribly poor. And that security can let you invest more freely with the rest of your money. If you use them wisely there is no reason to be afraid of buying annuities.

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    • Say Yes To Life profile image

      Yoleen Lucas 2 years ago from Big Island of Hawaii

      I've noticed annuities get a lot of bad rap - Suze Orman blasts them - but personally, I think they're great. I bought a John Hancock annuity 7 years ago, and am very happy with it. It accumulates at 7%, and when I'm ready to retire, it will pay 5%. That means for the rest of my life, I will get 2% cost of living increases. Will it make me rich? If I put a ton of money in there, it will!

      Since I am limited as to how much I can contribute annually, I plan on putting excess savings into coupon bonds and making arrangements for my own cost-of-living increases.

      Regarding the relatively low earnings on conservative investments like annuities and bonds - remember, the higher the return, the greater the risk. Beware of greed! I understand Suze Orman herself has $25 million, but only $1 million is invested in risky stocks.

      I have two warnings regarding annuities; first, NEVER withdraw the principal, since your income is based on that. Second, beware of when you buy them. I understand one way people are ripped off is, an unethical broker will sell an annuity to 70 year olds, who then have to sit on it for several years - in some cases, as long as 20 - before they can withdraw from it. I was 47 years old when I bought mine, and had to sit on it for 7 years, which didn't bother me because I have to be 59 1/2 before withdrawing from it. So you need to check clauses like that.

      Just my 2 cents. I noticed you've written a lot of hubs about investing. Am I accurate???

    • Cruncher profile image
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      Cruncher 2 years ago from UK

      I think you're pretty much spot on - annuities and other safe investments like that won't make you rich on their own. But once you've earned your money they can help to protect your standard of living in later life.

      Like you say the key thing is to understand how they work (and there is probably too much variation in contracts and small print out there) and ensure they meet your needs.

      I think annuities get a bad rap because they are often made too complex and sometimes sold by less than competent or downright immoral salespeople. But that doesn't mean they can't be a great tool when used right!

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