Why not skip the middleman?

Written by Hersh Stern Updated Wednesday, October 30, 2024

Many of my clients started out as “annuity skeptics.” They have heard enough about immediate annuities to be intrigued, but then questioned whether they can do better on their own. Usually, when we get into the details their skepticism boils down to two questions:

1. “It seems like the insurance company takes my money, takes its cut, and then pays me back what’s left. Can’t I do better by eliminating the middleman and just manage my money myself?”

2. “Okay, I'm convinced there's some value to this insurance stuff. But, how do I know which company has the best return and the lowest fees?”

If you’ve ever wondered whether an insurance company is just a high-paid middleman that can be removed in order to improve your returns, you’ll find the answer is a bit trickier than that.

In the strictest sense, yes, the annuity company is a middleman: it invests your money, takes a cut, and pays the remainder back to you.

However, that’s only part of the story. The insurance company isn’t just paying back to each annuity buyer a fraction of his or her own money.

With an immediate annuity the company actually is redistribution money between all of its annuity policy holders. In this way, if you live longer than your average life expectancy you'll receive premium back from the deceased annuitants who lived for less years than you.

This redistribution is how the insurance company manages its promise that no policy holder will ever outlives his guaranteed income stream. By definition, it’s a feature that you cannot reproduce on your own.

Sure, the insurance company makes a profit by offering this service, but that doesn’t necessarily mean it would be beneficial to “cut out the middleman.” This middleman provides a guarantee of income for life which you would be unable to reproduce for yourself.

Ultimately, the decision comes down to the size of your nest egg relative to your expenses in retirement. If running out of money is a serious concern, it’s probably a good idea to consider buying a life annuity with a portion of your portfolio.

As far as figuring out which company has the lowest costs...

My answer to this question is: don’t try to figure it out. You're looking for the wrong information.

It's true, if you’ve ever shopped for a mutual fund, you know the value of looking at expense ratios. These are an excellent predictor of fund performance. (Lower-cost funds tend to outperform higher-cost funds.)

However, when it comes to an immediate annuity it's more like how you would go about buying an individual bond, not a mutual fund. If you wanted to compare the bond offerings of different corporations you'd look at each bond's interest rate and the credit rating of the issuing company.

The same is true for immediate annuities. Rather than trying to reverse-engineer an annuity to determine the level of expenses baked in, evaluate your annuity choices based on:

1. The monthly payout each annuity provider promises, and

2. The credit rating of each annuity provider.

Those two metrics are the real keys to understanding the best value in a life annuity product.