In previous decades fee-only financial planners and journalists liked to criticize advisors who recommended putting an annuity in an IRA. However, there may be some good reasons. In California the state taxes the purchase of an annuity at 2.5% when purchased in a taxable account versus 0.5% if held in an IRA. Since annuity income is ordinary income when paid out then there is no tax opportunity cost to have it held in an IRA. (What I mean that if an asset produced tax advantaged income such as a long term capital gain then that asset should not be in an IRA).
The purchase of an annuity in a taxable account has the advantage of tax deferral until someone is in a lower income bracket when retired. It also has the advantage of reducing investment risk including reducing the risk that investing in bonds could result in loss of principal.
The big disadvantage of buying an annuity is that one may decide to annuitize and thus lose the flexibility to spend down principal. For example a grandmother may want to loan money to her grandchildren. If one locks in a fixed rate annuity when interest rates are low then they lose the flexibility to reinvest into bonds after rates have gone back up to normal levels.
The other advantage of an annuity is the mortality credits which act to boost yield. This is caused by the fact that the pool of annuitants are basically losing their assets when they die so the insurance company can give the savings from not having to make monthly payments to deceased customers to the surviving annuitants. This means those who die early subsidize those who live a long time.
Another criticism of annuitizing is that once locked into an annuitization (distribution), depending on the terms of the contract then you can’t get out of the contract. By contrast other assets have more flexibility.
The advantage of annuity is that the security of reliable monthly payments may facilitate taking greater risks with the other assets. However, I would caution people to realize that the ownership of annuity in the distribution stage is not the same as a bond. If you own a bond the way that it provides stability to the portfolio is that it is a source of cash from sale of the bond during a stock crash, which allows you to buy stocks at cheap prices. By contrast, an annuity that has begun to be annuitized would not return your principal on demand and thus an annuity owner could not take advantage of a stock crash since his money was tied up in an annuity. The difference between being an annuity owner versus a bond owner is that the annuity owner may be able to sit tight during a stock crash and afford the basic necessities thanks to his cash flow whereas the bond owner has extra freedom to sell bonds and buy stocks at cheap prices during a stock crash. Thus in terms of the long run big picture bond ownership provides a better outcome than annuities because an active investor could periodically sell bonds to buy risk-on assets during a crash. However the bond owner may have a smaller cash flow than the annuity owner because the annuitant is getting extra cash flow from mortality credits. However annuities have various costs imposed on them by the insurance company that issued the annuity and these may eat up the value of some of the mortality credits. If one is afraid that interest rates are too low and thus bonds will crash then they could benefit from the safety of basic fixed annuity which have no risk of dropping in value, since an annuity once annuitized, is a contract for monthly payments, rather than an asset that can be sold.
The biggest benefit of annuities is that if you live a very long life the annuity will still pay you and thus you won’t out of money. To make a portfolio that has no annuity do this one might have to reduce their withdrawal rate by 1%. The biggest risk of a basic annuity is that they are not indexed for inflation. By contrast, the classic idea of a safe withdrawal rate of 4.25% assumes that the portfolio return is higher than that and is used to adjust for inflation each year (assuming the markets cooperate). Thus a non-annuity financial plan with a safe withdrawal rate of 4.25% might be comparable to a fixed annuity yielding 6.25% because the annuity doesn’t compensate for inflation.
The best annuity in terms of being inflation adjusted with no management fees is Social Security.
Investors should seek independent financial advice about the hidden risks of annuities. I wrote an article “Annuities have more problems than benefits”.
Ultimately the best tax savings vehicles are to get long term capital gains in a taxable account. However someone could try some tax diversification by having the following:
a taxable account that seeks to get long term gains and tax free capital gains basis step-up at death (a retiree could hollow out the equity of this account with margin loans, but must be very careful not to get a margin call as a result of holding assets at the top of a bubble or of being too leveraged); a Roth IRA with no annuity in it; and a traditional IRA with a modest sized annuity in it.