Annuities are tools. They are acquired because the purchaser has a particular job to be done and is willing to exchange his money for a tool to do that job. In many ways, this exchange transaction is like the purchase of a hammer. The hammer has certain specifications — type and strength of the metal, length of the handle, size of the hammer head — and when purchased from a quality company, often comes with a guarantee that the product will perform as specified.
The important key to understand about this metaphor is that we generally do not buy a hammer simply because it happens to be cheaper, or lighter, or shinier than any other hand tool in the hardware store. We purchase it because we have a need, for example, to pound a nail into a piece of wood, or anticipate having a need in the future that we want to be prepared for, and we believe that a hammer is the best tool to fulfill that need.
In addition, there are many different situations where we might need a hammer, and each of those situations may call for a different one. Clearly, using a sledgehammer to drive a small nail into your drywall to hang a picture is the wrong tool for the job. Thus, the key in purchasing the right hammer is understanding the need and the job you're hoping to accomplish with it. Only once you understand the right situation for any particular hammer can you determine whether a hammer is the right tool for the job, and which type you need.
To complete the analogy, the key to decision-making when it comes to annuities is to first understand the problems for which the annuity can represent a solution. Only then can one actually determine whether an annuity is the right tool to solve the problem, and which sort of annuity will best accomplish the task.
We are all familiar with the kinds of problems that hammers solve, such as driving a small nail, pounding a large nail, or forcing a wedge between two pieces of wood to separate them. The problems that the annuity-as-a-tool are meant to solve are quite varied because of the broad number and types of annuity-tools available. That said, the problems that annuities solve — the needs that they meet — can be identified and separated into several general categories to meet several different client needs.
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1. Clients who need a known income stream.
For the client who requires a certain income stream commencing within one year, an immediate annuity is an almost intuitive choice. Providing income— certain as to amount, duration, or both—is what an immediate annuity does. But first we need to ask a key question: For how long will the income stream be required?
If the need is for an income for life, an immediate life annuity makes good sense. It is the only financial instrument that can guarantee a specific amount of income for as long as the recipient lives. It allows the purchaser to manage the risk that the asset base that is used to create the payments may not earn an adequate rate of return, or may not be large enough to provide enough payments for life (i.e., the risk of outliving one's assets). Some immediate annuities can be structured so that annuity payments will increase each year by a specified percentage. This is sometimes known as the COLA (cost-of-living-adjustment) option. Unfortunately, many insurance companies do not offer such an option in their immediate annuity portfolios.
Similarly, if the need is for an income specified for a period of years, an immediate period certain annuity may be an appropriate choice. It, too, manages the risk of an unknown future rate of return over the time period, and the risk that the asset base, or the dollars used to create the income stream, may not be sufficient to produce the income required.
One risk often cited by critics of immediate annuities is that the buyer has locked in current interest rates. This criticism is generally voiced during periods when prevailing interest rates are unusually low. How valid is this criticism? In the authors' opinion, it has merit, from an investment perspective. The interest rate used in the calculation of the annuity payout factor — the number of dollars, per thousand dollars of purchase payment that the annuitant will receive each period — is, indeed, locked in. Should prevailing interest rates rise over the period of time during which annuity payments are made, those annuity payments will not reflect that rise. However, the authors feel that from a risk management perspective, this criticism is misdirected. If the goal is to ensure an income level, the relevant risk is whether the dollars invested to produce that income can do so with certainty. A rise in prevailing rates would not present that risk, but a decline would. To transfer that risk from the annuity buyer to the insurance company, the buyer must incur a cost. Locking in the annuity interest rate is part of that cost.
It should be noted, though, that the changes in interest rates used in immediate annuity calculations over the past two decades have been far less dramatic than the changes in interest rates for short-term instruments such as savings accounts and certificates of deposit. While it is true that the purchaser of an immediate annuity in January 2009 is locking in an interest rate lower than would have been used for someone the same age and sex in, say, January 1982, the difference is not nearly as great as one might think. By the same token, if interest rates should trend sharply upward in the next 10 years, the locked in rates 10 years hence will probably not be substantially greater than the current ones.
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