Annuities are an oft maligned tool for retirement planning. Whether they are appropriate for you will depend on your individual circumstances.
What is most important is that you understand what they do and how they work.
There are many different types of annuities, but let’s talk about one particular breed of annuity for now, the immediate fixed income annuity. This is an insurance-based financial product, whose primary purpose is to provide consistent and secure cash flow for retirement. Consider it income replacement or creating your own pension with your personal assets. Immediate fixed income annuities are often sold quoting an interest rate that is not available in certificates of deposit or bonds. Generally, the interest rate quoted far exceeds more traditional fixed income products and is quite a lure to investors.
The mechanics of an immediate fixed income annuity are very simple: You make a deposit or premium payment to an insurance company. In return, the insurance company promises to make regular payments to you, usually monthly and for the rest of your life. Married couples can cover both spouses so that payments continue until both pass but at a reduced payment.
• You receive regular level payments that start immediately and last for life.
• You are no longer subject to market risk with the assets used to fund the annuity.
• You lose control of the assets you used to fund the annuity. You are locked into your monthly distribution and only your monthly distribution.
• If your lives end prematurely any excess balance is kept by the insurance company. In a sense, the insurance company wins because payments stop when you die or the second spouse dies if you chose to cover two lives.
• Over time even modest inflation will erode the purchasing power of your fixed dollar distribution.
• The guarantee is backed by the claims paying ability of the issuing insurance company, so choosing a highly rated company is critical.
What about that interest rate? Let’s do the math:
In late July, according to ImmediateAnnuities.com, a 65-year-old male could receive a Life Only Annuity with a monthly payout of about $2,523 or $30,276 per year with a $500,000 premium payment. This $2,523 per month is an average of four quotes from A rated national insurance companies.
For simplicity let’s round to $30,000/year or a 6% interest rate. That certainly exceeds the interest rate currently available on certificates of deposits or government and investment grade bonds. But here’s the catch: an immediate fixed income annuity does not have a true 6% rate of return because once you annuitize, you don’t receive your lump sum back – ever. A true 6% return would provide 6% annually or the same $30,000 PLUS the return of your lump sum at any point in time.
Remember the quote once attributed to Will Rogers: I’m not as concerned about the return on my money as I am the return of my money.
Let’s look at it with different life spans:
Age 65 to 81 – The insurance company pays the investor $30,000 per year. For the first 16 years and 8 months of the annuitization, the investor would (theoretically) be receiving his principal back. At this point, if the investor passed away at age 81, the real return would be 0%. This is because the annuity company has simply handed the investor back his own money ($500,000/$30,000 = 16.66667 years) and kept any earnings.
Age 82 to 90 – If the investor lived to age 90, the rate of return would still only be 3.4%, much lower than the guarantee of 6%. The reality is that $500,000 invested at 6% would pay you $30,000 per year, PLUS return the $500,000 principal. However, with the annuity, the insurer ceases payments on death and never pays back the original $500,000.
Age 91 and Beyond – Even if the investor lived 50 years beyond the original investment date, i.e. to age 115, the real rate of return would only equal about 5.6%. Not quite the guaranteed interest rate promised.
Two More Caveats:
• For our 65-year-old male, $30,000 in 2016 is not going to provide anywhere close to the same purchasing power in 2066, 50 years into his annuity when he is just approaching that 6% rate of return. You have to live a long time to get that 6% and its worth less when you do!
• The income payments are only an obligation of the insurance company, protected against default by the assets of the issuing company. This is not the same as FDIC insurance by the federal government. However, each state does provide a guaranty fund to protect annuity owners in case an insurance company faces financial trouble. You should know what is available for your state before you consider an annuity purchase.
As you can see, deciding to purchase an annuity is a complex affair. Immediate fixed annuities are among the easiest to understand. Any type of variable annuity has more moving parts and would require much more of an explanation.