A fixed annuity may be a good way to save for retirement when interest rates are high, but definitely not now. Low interest rates and the threat of inflation make fixed annuities unattractive for people saving for retirement — savers earn less interest while their future purchasing power erodes.
The perfect storm of low current rates and future inflation resulting from U.S. government policies that economists call financial repression is elaborated below.
Fixed annuities come in two flavors: immediate and deferred. With an immediate annuity, the buyer pays a lump sum to the insurance company and receives an immediate guaranteed income stream.
Look at the numbers before you invest.
Investing $100,000 in a single-life immediate annuity paying 2 percent with a 15-year payout period will give you $644 a month. The vast bulk of the income is your own principal being returned to you. At the end of 15 years, the annuity will be worth zero and you’ll have netted only $15,920 of total interest.
In contrast, with a deferred annuity, your initial deposit grows tax-deferred during the accumulation phase before the payout begins. Deferred annuities offer a guaranteed interest rate for at least the first part of the accumulation phase. The guaranteed rate is determined by the current interest rate. After the guarantee period is up, the rate resets annually.
This is a great feature when rates are high and you can lock in significant earnings each year. However, locking in 1-2 percent growth per year is not very appealing.
Furthermore, when you lock in a low guaranteed interest rate on an annuity, you’re ensuring you’ll lose purchasing power if there’s any inflation. Your monthly payout 10 or 15 years down the road will not buy as much as it would have at the beginning.
If you intend to rely on annuity income to pay expenses later in life without considering inflation, you may find yourself short.
Some annuities offer an option to purchase inflation protection that will increase the payout amount over time. But insurers don’t exactly give this away. In most cases it’s still a bad deal.
If you want a fixed annuity, wait until rates rise. Jumping into an annuity contract now will not be easy to undo later. Fees for leaving prematurely are generally prohibitive in the early years of the contract, making it financially painful to switch to a new one.
Instead of investing in an annuity, take a balanced approach, dividing your money between short-term bond funds and a diversified portfolio of U.S. and foreign stock funds.
In addition to the opportunity for future appreciation, many stocks today offer generous income, paying higher dividend rates than annuities, with the ability to raise dividends periodically.
Financial repression benefits U.S., hurts savers
The unattractive environment for annuities — and all but very short-term certificate of deposits (CDs) and bonds — results from financial repression. Financial repression describes measures by which a government channels funds to itself as a form of debt reduction. Its characteristics include large government debt; interest rates either capped or held down indirectly by the government; government ownership or control of domestic banks and financial institutions; and a captive domestic market for government debt.
Financial repression results from the Federal Reserve holding long-term interest rates at historic lows, while the Dodd-Frank Act restricts the banking and financial industries. Artificially low interest rates, plus a flood of government debt, are red flags for inflation down the road.
Financial repression benefits a debtor government. Holding interest rates down lowers the cost for Uncle Sam to issue and hold debt. Government control over banks and financial institutions lets the government create a market for its debt. The government can require banks to hold a certain level of reserves that will be invested in safe U.S. debt.
While the government comes out ahead, cautious investors who rely on fixed annuities, high-quality bonds and CDs hardly make a buck.
Low interest rates encourage companies and individuals to borrow and spend, bolstering the economy. Banking and securities regulation boosts confidence and greases vital financial gears that had ground to a halt, notes. But the downside is that financial repression requires the government to print more money, sharply increasing the risk of future inflation.
It’s certain that inflation will rise again someday, so avoid investments like fixed annuities that lock in today’s low rate.
Anna Pfaehler, CFP, is a financial planner in the Scarsdale office of Palisades Hudson Financial Group. She can be reached at email@example.com.
Palisades Hudson is a fee-only financial planning firm and investment advisor headquartered in Scarsdale, N.Y., with more than $1 billion under management. It offers investment management, estate planning, insurance consulting, retirement planning, cross-border planning, business valuation and appraisal, family-office and business management, tax preparation, and executive financial planning. Branch offices are in Atlanta, Ga., Fort Lauderdale, Fla., and Portland, Ore.