Johnson Investment Counsel

Beyond the Numbers Blog Series: Planning for Financial Peace of Mind

At its core, financial analysis, and therefore some aspects of wealth planning, is all about the numbers. Utilizing spreadsheets, projections, knowledge of tax laws, historical assumptions, and many other empirical datapoints is foundational in constructing a solid wealth plan.  But life is not a spreadsheet. Done well, we believe wealth planning involves weighing the objective calculations against the critical subjective factors of many life decisions. And it is not uncommon for the subjective to trump the objective, as it is so difficult to put a price or a numeric value on a feeling. Realizing this, we believe it is our role as advisors to help clients balance these factors and make well-informed decisions by “doing the math” and then subjugating the numbers to the broader, and more important, real-life context of what really matters to a family. By no means does this discount the importance of financial analysis. Instead, it is recognizing the proper role for the numbers as just one factor, not the only factor, to help make the decision.   

So this month we continue our series of articles that analyze many decisions clients face that require balancing the objective reality of financial analysis with the subjective value of helping clients sleep at night. We believe this integration is where the art of planning goes well beyond the science of finance. And while Google, and now ChatGPT (and other AI engines), can certainly retrieve and formulate data efficiently, they can’t look a person in the eye, read body language, notice tears welling up, or integrate family history to ensure financial decisions are aligned with a family’s core values.

Annuities: Peace of Mind for a Price

The Psychology of an Annuity Purchase

The decision to purchase an annuity might be the quintessential peace of mind financial decision facing many pre-retirees and retirees. It’s the ultimate tradeoff between that feeling of safety & security of stable monthly cash flow and the anguish of trying to understand a complex contract, and the pain of writing a very large check to an insurance company. But given the continued growth in sales of annuity products over the last 10 years (2024 was the third year of record-high annuity sales according to LIMRA, Life Insurance Marketing and Research Association), clearly something is attracting buyers.

When viewed through a purely scientific or empirical lens of historic market returns, this doesn’t make sense. It’s mostly common knowledge that over the last century or so in the US, real total return for equities has far outpaced returns from fixed income and cash and likely almost all annuities. Since 1926, in 100% of all 20-year rolling periods, the S&P 500 has been positive (with dividends reinvested).

With such a strong historical track record of disparity in returns for equities, why would someone own any fixed income beyond several years of living expenses? To extend that logic to annuities, why would anyone voluntarily turn over what is usually a large portion of their investment portfolio to an insurance company with a high probability of those dollars underperforming a diversified portfolio of equities? The answer, of course, is psychological. The answer, to put it bluntly, is fear: fear of seeing the red numbers on the screen/monthly statement, and for many people, fear of running out of money. But this tradeoff obviously has value for many people, as noted by the sales volume in annuities. This value is the same value provided by health, life, homeowners, and auto insurance companies: paying another party to offload risk. The risk being offloaded in this case is running out of money in retirement and clearly, people are willing to pay for this service as the security of a monthly paycheck is so valuable to so many.

“Pricing” this peace of mind is virtually impossible and is different for each personal situation. We don’t reflexively denigrate annuities if a person or family derives value in the tradeoff. But it is critical to know just how much this “feeling” of security is costing a family in the form of fees, liquidity impacts, and other limitations.

The Anatomy of an Annuity

Trying to summarize all the variances of the thousands of annuity products on the market would be impossible. The only thing longer is a typical variable annuity contract!

In short, an annuity is a contractual agreement between the purchaser (the “annuitant”) and an insurance company. In most cases, the annuitant turns over a large amount of cash to the insurance company, and in exchange, the insurance company promises some form of annual income for some period. The insurance company then pools this capital with other annuitants’ capital, which is invested in (hopefully) stable and secure securities that earn enough to finance the payments to customers. Again, this is admittedly an oversimplification as there are innumerable options with respect to timeframe, fixed versus variable, payout guarantees, return of principal, underlying investments, funding, cost of living adjustments, tax considerations. . . the list goes on and on. As with any major financial decision, the buyer must weigh the advantages and the disadvantages to align what works best for their family’s wealth plan.

Advantages

• Peace of Mind: First and foremost, people value the perceived certainty of cash flow hitting their checking account each month. For retirees, this is especially valuable as a replacement for their paycheck and can be very comforting.  
• Mitigate Sequence of Return Risk: One of the harshest detriments to retirees’ cash flow plans is sequence of return risk or, said differently, bad luck. This is the unfortunate circumstance of a large portfolio decline in the first year or two of retirement, which can adversely affect future safe withdrawal rates for decades. An annuity can blunt this risk as the annuitant could benefit from, in theory, not having to pull from depressed asset classes to fund cash flow.
• Mortality Credits: In calculating the implied annual cash flow “return” on an annuity purchase, one can compare the annual rate with alternative investment choices like fixed income or equities. Often, this percentage return is higher with the annuity than with comparable fixed income due to the benefit of mortality credits. While somewhat of a morbid concept, mortality credits are essentially the insurance companies’ ability to pay higher rates when deceased participants’ funds are reallocated to the remaining pool of annuitants.

Disadvantages

Despite the value, consumers can only truly judge the value of a product if they know the price they are paying. To put it kindly, this is where the annuity market can get opaque. As with any major financial decision, caveat emptor!

• Fees: While there are many quality, low-cost options on the market, the landscape is littered with annuities with high annual fees when compared to most asset management fees. Additional options on the contract (riders) also layer in additional fees which may be very difficult to evaluate and calculate.
• Complexity: Annuity contracts are notoriously long and confusing and, in our view, this is a feature, not a bug, for the insurance company. These contracts can be long and filled with so much legalese most of the annuity salespeople can’t even explain them. This is a red flag, but not all annuities are like this, and there are many on the market that are clear, concise, and easy to understand.
• Illiquidity: Every annuity contract is different, but some have surrender periods where the annuitant cannot access the money for a period of years at the beginning of the contract without a severe financial penalty. In addition, the annuitant does hold the risk of dying early in the contract and not “making back” the cash they paid. This risk can be mitigated with various riders (joint and survivor, period certain, return of premium, etc.), but this lowers the payout to account for this risk being taken on by the insurance company.
• Potential Impact on Heirs: Without the aforementioned protection of some return of principal, the premature death of the annuitant can severely cut the decedents’ passing of assets to their heirs. An investment portfolio can transfer fully and seamlessly to children, grandchildren, trusts, or charities (assuming solid estate planning). An annuity could detract from this inheritance.
• Insurance Company Stability: The word “guaranteed income” is dubious and can be very dangerous. In reality, the income paid by an annuity is only as good as the quality of the insurance company backing the payout. There are many high-quality, solid insurance companies with long track records of dependable payments. As the financial crisis of 2008 taught us, even the most stable companies can risk insolvency in times of severe economic distress.
• Inflation: Many annuity contracts pay flat amounts and lose purchasing power year after year to inflation.  With only 3% inflation, purchasing power can be cut in half in only 24 years, a timeframe shorter than some retirements these days. Inflation protection riders can be purchased, but they can be cost-prohibitive or may start with much lower monthly income for the lump sum employed. Delaying Social Security can help offset this disadvantage, as can a laddering of annuity purchases over multiple years but this is a topic for another article!

Bottom Line:

Given the substantial impact on retirement cash flow strategy, the decision to purchase an annuity should not be taken lightly. In our opinion, people should work with a trusted advisor who does NOT benefit financially from the sale of the product itself. To be fair, advisors charging asset fees would benefit from a client’s decision not to purchase a large annuity, as assets under management would, in theory, not be reduced. In this case, it’s important to work with a fiduciary advisor who is mandated to act and advise in the client’s best interest, regardless of who receives compensation. It may very well be the family has a degree of risk aversion that they value the advantages of an annuity much more than the disadvantages, and that’s fine. How could an advisor disagree with something so subjective? Instead, it’s our role to educate, inform, and apply an annuity’s impact to our clients’ personal situation so they can make the best decision to help them sleep at night, regardless of the financial products employed.

Other articles in our special Beyond the Numbers Blog Series: Planning for Financial Peace of Mind.

• Should We Pay off the Mortgage Before or In Retirement?
• Should We Really Wait Until 70 to Claim Social Security?

Disclaimer:

Johnson Investment Counsel cannot promise future results. Any expectations presented here should not be taken as any guarantee or other assurance as to future results. Our opinions are a reflection of our best judgment at the time this material was created, and we disclaim any obligation to update or alter forward-looking statements as a result of new information, future events or otherwise. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors prior to taking any action.