Wednesday, April 22, 2015

Annuities, Revisited

Let's crank some numbers on Annuity Contracts.

I discussed annuities in a previous posting, and today, I was looking at investments and thought about how nice it would be to have "guaranteed income" for life, with an annuity.  I realized, however, that I had not really cranked the numbers on Annuity contracts.

Vanguard has a site to calculate and compare annuity contracts.   They can also e-mail you customized quotes.  They did this for me, comparing three insurance companies, and the prices were all within a few thousand of each other.

Vanguard, by the way, was very professional, and did not hype or push annuities, even going to far as to say they do not recommend putting more than half your portfolio into one.   Myself, I cannot see putting more than 10% into one.

The scenario we presented was as follows:
Married Couple, age 55 & 50
Retiring in 10 years.
Monthly Payment, $1000
Purchase cost:  $160,000
This is a joint life annuity that would pay out until the last spouse died, $1000 a month.

Is this a good deal, or not?   Well, as with everything else, "do the math".

Using our compound interest calculator  we can crank the future value of $160,000 after ten years:
At 3% = $215,026.62

At 5% = $260,623.14

At 7% = $314,744.22
Let's assume a rate of return of 5%.  If we decided to invest this money, instead of buying an annuity, by age 65, we would have $260,000 or $100,000 more than we have today (yea, compound interest!!).  And that's only a mere decade from now.

Now, how much monthly income would $260,000 generate?  Using the 4% or 5% rule,  this would generate about $10,400 to $13,000 for about 30 years or so, factoring in an inflation value of a few percent.  As we can see, this is akin to what the Annuity company would pay out ($12,000 a year) without any inflation factor.

Of  course, there are some differences between the scenarios - we are comparing apples to oranges.   The annuity pays out until you die, which could be age 90 or more, for many people today (let's assume, for the moment, that living to 100 isn't in the cards - it still is a relatively rare event these days).

If we assume age 90, then the annuity pays out for 30 years (age of youngest spouse is 60 when payout starts).  But even if you live to 100, which seems unlikely, the amount of money you've paid into this annuity is still a lot more than you'd get out, if you merely invested it at 5%.

But of course, no one is guaranteed a rate of return of 5% are they? And this is where an annuity provides some security - provided the company backing the annuity is solvent, and if not, that the State where you lived when you signed the contract insures annuities, and then only for a certain amount.  For Georgia, this is $300,000 per annuitant or $250,000 in cash surrender value.

Now, if you want an inflation rider, the costs escalate rapidly.   For a 3% inflation rider, or for one tied to the CPI, the amount, oddly enough, was about the same (I am guessing the underwriters are not afraid of inflation).  The amount jumps to about $245,000.  Ouch.

Now again, using the 4% or 5% rule, we saw that if we had about $260,000 at retirement, this would be sufficient to provide about $1000 a month for 30 years or so, which is the about the life expectancy we can realistically expect.  So this is no real bargain, in my opinion.

This calculator, from Bankrate, helps you compare Annuities to Investments.   In this instance, the amount of $260,000, invested at a paltry 3% rate of return, would last for 35 years with $1000 a month being withdrawn.  At 5%, it goes off the charts.  And this is where it gets interesting.  As an oldster, you can't afford to risk investing in high-rate-of-return investments.  But the annuity company can, as they can invest for the long-haul (longer than you will be around).

So why do people buy annuities?  Well, there is the "peace of mind" factor - and as I have always said, when someone tries to sell you "peace of mind" you should keep one hand on your wallet.  In this case, the insurance company is taking a big piece of pie off the top, which is to be expected.  They are also assuming risk that they can make rates of return that are consistent, and that some miracle aging cure won't be discovered in your lifetime (if people lived to be 120, they'd go bankrupt!).

There is another aspect of annuities - and the Vanguard people were very clear on this - once you buy one, it may be hard to say, "You know, I've changed my mind, I'd rather have the money back!" - at least without paying a penalty.   Some annuities do have a cash surrender value.   I suppose you could try mortgaging an annuity through a structured settlement company, but you'd end up losing your shirt, as they would want another "taste" of your money.   So before you put money into an annuity, make sure you won't need it down the road, say, to buy a house or something.

My conclusion?  I don't think it is necessarily a great investment.   I suppose I might put half ($80,000) into one or something.  But then it would pay out a paltry $500 a month and what would be the point of that?

With a diversified portfolio, even a low rate of return will probably beat an annuity in the long run.  But we'll see.