A few years ago I attended a conference and one of the speakers, a PhD in Economics, did not understand why many more people did not choose to buy an immediate annuity, and annuitize it to fund their retirement. You can buy an immediate annuity by paying a lump sum to an insurance company. When you annuitize it, the insurance company pays you a guaranteed amount every month until you die, based upon your age, interest rates, and some insurance assumptions. Annuitizing is the formal and irreversible process and decision to start taking these withdrawals for life.
The amount you would receive monthly by annuitizing is typically much more than you would be able to generate and distribute from a diversified stock and bond portfolio with the same amount of money, without risking too much of your principal. This was the reasoning of the PhD in Economics as to why more people should annuitize. An annuity can be a good way for someone to store up what might otherwise be a fragile income stream for their retirement, and shift some of the risk to the insurance company. It is prudent for many people to use annuities to help fund their retirement. Of course, they do come with costs.
As I mentioned, the insurance company pays you a monthly sum until you die. Once you die, your payments are cut off, and your heirs do not get any of your money back.
Some people will die soon after annuitizing. The insurance company considers these factors along with other actuarial data, which gives them the ability to make higher payments than they would otherwise be able to. Also, someone investing and distributing income from their portfolio of stocks and bonds wouldn’t intentionally spend it all the way down. When you buy an annuity that is what you would be doing theoretically, because you are not going to get any of that money back.
One reason more people don’t buy these annuities is that no one wants to be the one who gets hit by a bus two months after buying the annuity, just to give their hard-earned money to their insurance company instead of their family. That is hardly an “irrational” fear, and I can understand why people might feel that way.
Keep in mind though, that buying one of these annuities might be one of the tradeoffs that make sense for you when doing your financial planning. For many people without a lot of assets or a guaranteed retirement income, they might be a good idea – as long as you buy a low-cost one from a company such as Vanguard or TIAA-CREF.