Financial advisers (and columnists) like to tell investors to build things. Build a portfolio. Build a bond ladder. Build an estate plan. One suggestion you're likely to hear more often is to build your own annuity. It's not necessarily a bad idea, since the product, as traditionally sold by insurers, can have serious shortcomings. But assembling one can be tougher than it looks.
Fixed annuities, which are designed to provide guaranteed regular payments to the policyholder over the term of the contract (either starting immediately or deferred to a certain date), are increasingly popular. Industrywide, first-quarter sales totaled $20.2 billion, up 5 percent from a year earlier, according to research firm Limra. New York Life Insurance saw sales of fixed immediate annuities jump 45 percent, to $474 million, in the same period. The gains are likely to continue. Many baby boomers, says Chris Blunt, executive vice president at New York Life, simply haven't saved enough for retirement and are using annuity payouts "to supplement Social Security and cover basic expenses."
Of course, fixed annuities have their limitations. Among the biggest: locking up principal. In handing over a lump sum to an insurer, you face either surrender charges (with a deferred product) or giving up ownership of your money (with an immediate annuity). Yes, there are fixed immediate policies that provide income for heirs, but such provisions typically translate into smaller payouts during your own lifetime. All of which argues, seemingly, for the do-it-yourself approach: Sidestep insurers, build your own annuity and keep control of your money.
The process can be fairly simple. Jim Lorenzen, founding principal of Independent Financial Group in Moorpark, Calif., offers the example of an individual with $100,000 to invest in a deferred annuity, one that matures in, say, five years. Instead, the person could invest around $89,500 in five-year Treasurys with yields (recently) of 2.25 percent. The balance of $10,500 is invested in an S&P 500 index fund.
The Treasurys will return $100,000 at the end of five years the $89,500 in principal, plus interest. If the stocks tank and lose half their value, the investor ends up with $105,250; if the stocks stand pat, the investor ends up with $110,500. And if the stocks earn 9 percent a year, the investor ends up with about $116,200. In each case, there's a guaranteed return, there's profit, and the investor, as opposed to an insurance company, holds the cash. Instead of Treasurys, "you could use corporate bonds anything you feel comfortable with where there's a guarantee," Lorenzen says.
Want something simpler? Steve Maersch, a retired journalist in Greendale, Wis., recently wrote me with an idea for building an annuity. He starts with two 61-year-old retirees living in Wisconsin in 1986. The first spends $100,000 on a fixed immediate annuity that pays $6,492 a year. After 25 years, she dies, having received $162,300. The annuity dies too.
The second woman invests $100,000 in Vanguard's Wellesley Income fund, also withdrawing $6,492 each year. At the end of 25 years, she dies, having received the same $162,300 in income. But there's almost $360,000 left at Vanguard for heirs or charity, thanks to Wellesley's average annual return of 10.2 percent. (Maersch also ran the numbers starting with the fund's four worst years between 1986 and 2010, which included a drop of 9.8 percent in 2008. At the end of 25 years, the account still held almost $112,000.) "In many years of number-crunching," he says, "I have never found an annuity that couldn't be slaughtered by a good mutual fund."
So what's not to like about the DIY route? Keep the following in mind:
Risk. Yes, Treasurys and corporate bonds tend to be safe(r) investments. But state governments require insurers to maintain specific levels of capital to make annuity payments and can guarantee annuities (typically, up to $100,000) if an insurer fails. "When you have regulators looking over an insurance company's shoulder, there's protection that you aren't going to see if you do this yourself," says Don Taylor, assistant professor of finance at Penn State University.
Discipline. Say you've done your homework and built a sturdy annuity. Great. But...will you have the discipline to keep from fiddling with it? Or will the next hot tip inspire you to undo your handiwork? Most people are hurt more by their behavior than by their investments, says Lorenzen. "If nothing else, an insurance company will make a contract with you and stick to it."
Longevity. Maersch allows that Wellesley, or any mutual fund, could have some bad years, which could hurt the long-term prospects of a home-grown annuity. It's precisely on that point the assurance that an annuity will still be pumping out cash 30 years down the road, if necessary that insurers have an edge, says Blunt, of New York Life. A do-it-yourselfer might be able to match, for a time, the payout, he says, "but you can't match the longevity protection" from a highly rated insurance company.
While it's important to note that the insurance industry has more experience than you do in guaranteeing payments for decades, there are still good arguments for getting out your hammer and nails and building your own annuity. Just consider bringing in a contractor (such as your financial adviser) to help.