Plenty of people shudder when they hear the word, “annuity.” Many financial advisors sell them as if they’re life preservers. But they’re usually filled with holes.

Variable annuities, for example, are widely oversold. An advisor might croon, “These products guarantee that you won’t lose money. They’re also linked to the stock market. So when stocks rise, the value of the annuity rises too.” In 2005, columnist Scott Burns published, Seven Reasons To Avoid Variable Annuities. Today, his logic hasn’t lost its sting. Investors pay stratospheric charges, averaging 2.24 percent per year. That hurts investment returns. Variable annuities can also attract unnecessary taxes. And if investors withdraw early, they usually pay stiff exit penalties.

Fixed-income annuities, however, look more attractive to retirees. Here’s how most of them work: You pay an insurance company a lump sum. In exchange, they provide a regular income stream for life. It’s much like buying a defined benefit pension. But in most cases, there’s no upward adjustment to cover inflation. *

Retirees like them because a stock market drop wouldn’t affect the income stream. At immediateannuities.com, you can estimate how much monthly income you might receive. For example, assume a 62-year old retired couple gives an insurance company $500,000. Based on average estimates from a variety of providers, they should be able to expect about $2,192 per month from a fixed-income annuity. That’s 4.38 percent per year.

Adam Beaty is a Certified Financial Planner with Bullogic Wealth Management. He says some clients benefit from a fixed income annuity to cover their basic needs. “Everyone has a minimum floor of needs,” he says. “This floor should cover food, transportation, housing, medical, and utilities.” He recommends fixed income annuities to cover these basic needs, while a traditional portfolio could cover anything extra.

But not everybody likes fixed income annuities. Dennis J. De Kok is a Certified Financial Planner with FCM Financial. He says, “I strongly dislike annuities of any kind. [Those that] benefit the most are the ‘financial advisors’ who collect high commissions. Just because there isn’t a stated expense ratio on income annuities, understand that the insurance company is investing the money and only paying the client a small percentage of the returns.”

Let’s go back to that 62-year old retired couple and compare two options: They could buy a fixed-income annuity that pays 4.38 percent per year. Or, they could withdraw an inflation adjusted 4 percent from a diversified portfolio of low-cost index funds.

According to inflationdata.com, U.S. inflation averaged 3.15 percent per year between 1913 and 2018. Over the past 30 years, inflation averaged 2.5 percent. Here’s how the withdrawals/payouts might stack up if inflation averaged 2.5 percent over the next 30 years.

Annual Inflation-Adjusted Withdrawals of 4% vs.
Fixed-Income Annuity Payments of 4.38%
Assuming $500,000 Starting Point

Retirement Year Investment Portfolio Withdrawals
(4% per year, inflation-adjusted)*
Fixed-Income Annuity Payments (4.38% per year)
1 $20,500 $21,900
2 $21,012 $21,900
3 $21,537 $21,900
4 $22,076 $21,900
5 $22,628 $21,900
6 $23,193 $21,900
7 $23,773 $21,900
8 $24,368 $21,900
9 $24,977 $21,900
10 $25,601 $21,900
11 $26,241 $21,900
12 $26,897 $21,900
13 $27,570 $21,900
14 $28,259 $21,900
15 $28,965 $21,900
16 $29,690 $21,900
17 $30,432 $21,900
18 $31,193 $21,900
19 $31,973 $21,900
20 $32,772 $21,900
21 $33,591 $21,900
22 $34,431 $21,900
23 $35,292 $21,900
24 $36,174 $21,900
25 $37,078 $21,900
26 $38,005 $21,900
27 $38,956 $21,900
28 $39,929 $21,900
29 $40,928 $21,900
30 $41,951 $21,900
Total 30-Year Income Received Total 30-Year Income Received
$899,992 $657,000

Over 30 years, the retiree taking out an inflation-adjusted 4 percent per year would have withdrawn $899,992. The retiree with the fixed-income annuity, however, would receive just $657,000 over the same time period. That’s $242,992 less.

What’s more, fixed-income annuities aren’t very flexible. Imagine a retiree wants a one-time boost in cash. Perhaps she wants to upgrade her home or withdraw extra money for her grandchild’s education. Or, she might find out that she has just 2 years to live. While she’s still strong enough, she might want to travel the world. But if she owns a fixed-income annuity, she can’t increase her payments. The insurance company, after all, really owns her money.

However, a financial advisor might counter with this: “Fixed-income annuity payments are guaranteed. If you invested in a portfolio of index funds, you could run out of money if the stock market falls.”

Using portfoliovisualizer.com, I looked at the biggest two-year stock market decline over the past 80 years: 1973-1974. U.S. stocks cratered 41 percent. Assume somebody had $100,000 invested: 60 percent in stocks and 40 percent in bonds. Assume they retired on the eve of the market crash, and they began to withdraw an inflation-adjusted 4 percent per year. If they died 30 years later (in 2003) they would have died with about $258,599.

Yes, you read that right. They could have withdrawn an inflation-adjusted 4 percent per year, and they would have left their heirs with more money than they started with. But if they had purchased a fixed-income annuity, their heirs wouldn’t receive a dime. Fixed-annuity payouts usually die when the retiree does.

You might wonder, however, about history’s worst market crash. U.S. stocks fell 8.42 percent in 1929. In 1930, they fell another 24.9 percent. In 1931, they cratered a whopping 43.34 percent. And in 1930, they dropped another 8.19 percent. A fixed-income annuity salesman might show you these numbers, while rubbing his hands behind his back.

But according to Michael Kitces, a Partner and the Director of Wealth Management for Pinnacle Advisory Group, the four percent rule would have stood up well. He back-tested rolling 30-year periods starting in 1871. In every case, retirees with 60 percent in stocks and 40 percent in bonds would have had money remaining after 30 years, if they withdrew an inflation-adjusted 4 percent per year.

Vanguard takes it one step further. They back-tested stock and bond market returns starting in 1926. But unlike Michael Kitces, they didn’t use rolling 30-year historical periods for their assessment. Their online tool calculates 100,000 historical scenarios for stock and bond market returns, coupled with different rates of inflation. For example, over the 30 years from 1929 to 1959, inflation averaged a paltry 1.63 percent per year. But what if inflation were as high then as it was in the 1980s? Would retirees have anything left, if they withdrew an inflation-adjusted 4 percent per year? In other words, Michael Kitces measured what happened over rolling 30-year periods. In contrast, Vanguard’s Monte Carlo Retirement Nest Egg Calculator measures what could have happened.

And it still looked good for the 4 percent rule. According to Vanguard, 91 percent of the time, a retiree could have withdrawn an inflation-adjusted 4 percent for 30 years…and they would have still had money left to gift to their heirs. In contrast, most fixed-income annuities would have nothing left to give.

That’s why they might be a great deal for advisors but a bad deal for retirees. Fixed-income annuities pay less money over time. And when the retiree dies, the insurance company wins.

*Note: Inflation-protected annuities increase payouts with inflation. But they initially pay 20-30 percent less than most fixed-income annuities, and the increases are often capped after a certain number of years. Insurance companies, after all, still find a way to win.

Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas