Annuity providers will tell you their products are the only way to guarantee lifetime retirement income, outside of Social Security and a defined benefit pension. While that may be true, the promises and potential are frequently misrepresented or misunderstood. Advisors need a realistic grasp of exactly how and where annuities can best fit in a comprehensive retirement plan.

Ensuring Basic Needs
“Income annuities are a great choice for ensuring that basic needs—housing, food, utilities, etc.—are covered,” says Elle Switzer, director of annuity product management at TruStage (formerly CUNA Mutual Group) in Madison, Wis.

They can, she says, safeguard retirees against running out of money. Unless, of course, the retiree ends up needing far more than anticipated.

“The spending-needs calculation can be very challenging, and the temptation has been to rely on rules of thumb … which aren’t optimal for specific individuals,” says Matthew Drinkwater, corporate vice president of annuity and retirement income research at LIMRA and LOMA, the industry data trackers in Windsor, Conn.

Advisors, he says, should try to understand each client’s spending patterns and account for likely variations. “If an annuity can keep the roof over the head and food on the table, then maybe the remaining portfolio can cover the luxury hotel stays and fine dining,” says Drinkwater.

A Puzzle With Many Pieces
To that end, many advisors suggest comparing a client’s nondiscretionary living expenses against his or her total retirement income from Social Security, pensions and required minimum distributions (RMDs) from retirement accounts. “If there is still a gap,” says Ari Fischman, a financial life advisor at Telemus in Southfield, Mich., “using an income annuity would [make up the difference] faster than other assets.”

But another perspective is to consider a bucketing strategy. Adam Handler, vice president of product management at SPS Family in New York City, suggests dividing assets into short-, medium- and long-term goals. “Income-based annuity solutions may fit this final bucket,” he says, “where there is no concern for liquidity, allowing the assets to serve the purpose of generating a consistent and guaranteed income stream.”

During the decumulation phase of life, as the retirement years are sometimes called, investors are no longer looking for long-term growth. “Annuities are not designed to have the highest returns or be the most robust investments,” says Tim Rembowski, vice president of member success at DPL Financial Partners in Louisville, Ky. “They are designed to provide an amount of guaranteed income payments even if you live well into your 90s or beyond. Just like people buy life insurance in case they die young, you buy annuities should you live past your life expectancy.”

Steve Parrish, co-director of the American College of Financial Services’ Center for Retirement Income in King of Prussia, Pa., agrees. “Annuities should be looked at as longevity insurance,” he says. “No one wants to eat cat food and live in their car because they exceeded their life expectancy.”

A Hedge Against Forced Selling
An annuity’s payment stream can be especially valuable in a down year for the market. The guaranteed income “acts as a hedge against the forced selling of parts of a portfolio at depressed values to fund living expenses,” says Theodore Saade, a managing senior partner at Signature Estate & Investment Advisors in Los Angeles.

Saade suggests that annuities make up no more than 20% of a household’s liquid net worth, however—a “sliver of the portfolio,” he says, “that clients can look to as part of the ‘sleep well at night’ portion of their overall plan.”

Annuities are often viewed as an antidote to financial uncertainty. “In today’s hyper-uncertain economic environment, protecting retirement income has become a top goal for investors,” says Cyrus Bamji, chief communications officer at the Alliance for Lifetime Income in Washington, D.C.

Some experts, he says, even consider “protection” as a new asset class—a category that he says annuities can fill perfectly. “Adding annuities to the mix can create a comprehensive, more resilient, and modern retirement portfolio,” Bamji says.

Not For Income Only
But not all annuities are designed strictly for income. “While I definitely believe retirees need more income that is protected for life, I’m not convinced people need more income that is fixed,” says David Blanchett, the Lexington, Ky.-based head of retirement research at PGIM, the investment management group of Prudential.

Fixed annuities generate a specific, contractually guaranteed income for a designated time period. But an annuity with a “market component,” Blanchett says, has “the potential to generate more income over a retiree’s life.” There is a greater degree of risk, but “that could be fine,” he says, if other assets are invested wisely.

Annuities with a market component include fixed-index annuities, which link performance to a market index and thereby enable partial upside, in exchange for complete downside protection (they cannot lose value), and variable annuities, which invest assets in mutual-fund-like subaccounts with fluctuating values.

Variable annuities carry more risk, which is why one popular type is the registered index-linked annuity (RILA). These limit the downside possibilities while also capping the upside potential.

These products can be “used as a protected growth strategy,” says Corey Walther, president of Allianz Life Financial Services in Minneapolis. They “can serve as an anchor to allow the rest of a portfolio to stay invested in equities for greater long-term growth potential,” he adds.

Guaranteed Lifetime Withdrawal Benefits
Most variable annuities also come with an optional guaranteed lifetime withdrawal benefit, a rider that can be added on—for an extra fee—to provide a minimum payout regardless of market performance. “Annuities do not have to be annuitized to generate guaranteed income,” notes Glen Franklin, assistant vice president at Jackson National Life Distributors, a unit of the Franklin, Tenn.-based life insurance and annuity provider.

This is “where confusion can arise,” says Wade Pfau, Dallas-based author of the Retirement Planning Guidebook and co-creator of the Retirement Income Style Awareness planning tool. “It does take some effort on the part of individuals to understand how the provisions work.”

Kailyn Paolucci, a wealth advisor at Bartlett Wealth Management in Cincinnati, strikes a similar note of caution. “While the income may be guaranteed, there are other details that often get lost,” she says, citing fees, commissions and early surrender charges, among other considerations.

Annuity Limits
To be sure, annuities have drawbacks. They may “provide some comfort, [but] you surrender liquidity and market upside,” says Matthew Wolniewicz, president of Chicago-based Income America.

Certainly no one should put all their investable assets into annuities. Keep “sufficient savings in a discretionary spending and/or emergency fund to provide a buffer against the need to take excessive withdrawals,” says Frank O’Connor, vice president of research at the Insured Retirement Institute in Washington, D.C.

Still, with interest rates up, annuity payouts have grown. “In some cases, these rate increases have outpaced alternative options … such as bank CDs,” says Scott Gaul, head of individual retirement at annuity provider Prudential in Newark, N.J.