Annuities in retirement often promise financial security by offering a guaranteed income stream for as long as they live, but are they worth the cost? While there may be some tax advantages, these benefits can often be achieved through tax-deferred accounts within a comprehensive wealth management plan. For example, implement the strategy in a tax-deferred plan (IRA, 401k, 403b, etc.). The real issue with annuities is their high fees and unexpectedly short longevity. You pay substantial costs to a salesperson and an institution for a relatively simple bond strategy that you could replicate at a much lower cost. Here’s why building a do-it-yourself (DIY) annuity might be a better alternative.

The High Costs of Annuities

When you purchase an annuity, the company invests the upfront payment in a portfolio to provide you with a fixed income stream. Their profit comes from what they earn on their investments minus what they pay you. However, the real kicker is the hefty fees that annuity providers charge—typically ranging from 0.95% to 1.75% annually—along with commissions and surrender charges. These expenses significantly drag down the annuity income stream to the recipient.

Instead of paying these high fees, you can replicate the strategy annuity companies use. By investing in a systematic bond portfolio strategy with very low (index) fees, you can create a stream of income that meets your needs without the high costs. This DIY annuity methodology is illustrated in the downside risk management chapter of the book Do-It-Yourself Wealth Management by Stanley J. Kon and as an upcoming feature in WealthFluent software.

Why Retirees Seek Annuities

Most retirees are in the de-cumulation phase of their lifetime, meaning they are drawing down their wealth. One of the biggest concerns for retirees is determining a stable, nominal risk-free monthly income stream for the rest of their lives. Since life expectancy is uncertain, many fear outliving their savings. This concern often drives people to purchase annuities, which are essentially insurance contracts designed to eliminate the risk of outliving your money. However, while annuities provide peace of mind, they come with the price of high fees and the loss of the annuity from premature death. The question becomes: is it worth buying the insurance, or would it be better to self-insure by building a DIY annuity with properties that satisfy unique personal preferences?

Evaluating the Cost of Insurance

When deciding whether to purchase an annuity or build your own, there are three key factors to consider:

1. The Risk-Neutral Value of the Insurance Contract: Compare the value of the annuity contract to what you could achieve through a DIY approach. Insurance companies can’t offer you more than what’s available in the current investment marketplace. The fees are bundled into the contract price, but you can determine the expected internal rate of return on the annuity to see how it compares to bond market rates.

2. The Value of Outliving Your Expected Lifetime: One of the key benefits of an annuity is the insurance against outliving your expected life span. However, if you live longer than expected, this could increase the value of the annuity to you. But is this added value enough to outweigh the high fees and investment loss of premature death?

3. The Risk of Dying Before Your Expected Lifetime: If you die earlier than expected, the purchased annuity ends (zero value at that time) and your heirs do not inherit anything from this investment. A DIY annuity, on the other hand, allows the remaining assets to be passed on to your heirs. This premature death feature and its effect on valuation tends to get little or any attention from both the commercial provider of annuities or the purchaser.

DIY Annuities: A Better Alternative?

In many cases, especially now, the cost of  a commercial annuity far outweighs the benefits. By building a DIY annuity using a few Treasury bond funds, you can achieve a similar income stream with lower costs and no default risk. For example, using three Treasury funds, you can create a portfolio strategy that is immunized from interest rate risk while ensuring a steady income stream for any number of years you require. This strategy allows you to avoid high fees while maintaining control over your investments, including as personal circumstances evolve

In the 1980s, when Treasury rates were above 10%, annuities made the sale of annuities easier. Even though the drag from high fees was there, it was less noticeable as a lower percentage of the expected return from investments. Today, lower interest rates mean the fees take a bigger percentage bite out of your annuity income stream and even more so from the lack of benefitting from the reinvestment of those high fees. The industry has not significantly reduced these fees during lower interest rate environments, which means they profit from less-informed consumers and their fear of running out of money.

The Importance of Personal Attributes and Risk Preferences

Of course, personal attributes and risk preferences also play a role in the decision to buy or build. If you expect to live significantly longer than the average person in your cohort, a commercial annuity might provide better value, but that is assuming a lot of premature death risk is nonexistent If you have average or below-average life expectancy, a DIY annuity will be more cost-effective.

The downside risk of dying earlier than expected is often overlooked in valuation models for annuity contracts. With a DIY annuity, the assets that are generating the income stream remain in your estate, ensuring that your beneficiaries can inherit the full value of these income-generating investments.

Conclusion: Buy or Build?

The decision to buy a commercial annuity or build your own depends on several factors, including the cost structure, your personal health attributes, and your risk preferences. For many, the DIY option is the superior choice due to its significantly lower implementation fees and flexibility. 

It is easy to replicate the profile of a commercial annuity using your own investments in Treasury mutual funds, ETFs or other investment-grade bonds without paying for the added insurance and management fees. A sensible method to include the same risk effect of living longer than expected is to select a much greater expected lifespan (i.e., 95, 100 or 110 years) than what the mortality tables indicate when creating a DIY annuity.

In summary, while commercial annuities may appear to provide a valuable service for some, the all-in high costs and restrictions associated with them make a strong case for building your own income stream. By doing so, you can achieve your financial goals while keeping more of your money working for you. As with any investment decision, it should be made in the context of what it contributes to your comprehensive lifetime wealth portfolio plan that includes all assets and liabilities.