The following is a guest post from Marotta Asset Management.
Ever-popular annuities sometimes sound too good to be true, which in itself is probably a good reason to avoid them.
An annuity is a financial product sold as a way to collect and grow funds and then later receive those funds as a steady cash flow during retirement. Annuities have many flavors and features that vary this basic principle, but the basic terms you will hear are "deferred or immediate" and "fixed or variable."
A deferred annuity puts off taking withdrawals, whereas with an immediate annuity you can take withdrawals right away. A fixed annuity has a preset withdrawal amount that does not adjust for inflation. A variable annuity is tied to the performance of some investment choices.
Commission-based advisors with insurance licenses sell you whatever form of annuity would have performed well over the past decade. They say they are fee-based, at least partly to sound more like fee-only financial planners. If you are confused by these distinctions, then 93% of the financial services world who can't call themselves fee-only are doing their jobs well. You do well when you remember that fee-based is not the same as fee-only.
Let's review the math behind an immediate fixed annuity. This type of annuity receives a fair amount of seemingly scholarly press trying to justify including this product as part of a balanced portfolio.
Imagine that Thomas and Martha Jefferson, ages 64 and 62, respectively, purchase an immediate annuity that will pay them a guaranteed 6% annual return. If they have $500,000, they would receive $30,000 every year for the rest of their lives. This income, added to their Social Security, would comprise the spending for their lifestyle.
This scenario sounds fair. After all, who wouldn't want to have earned 6% over the last 10 years during these mixed markets? Earning 6% guaranteed feels like a good exchange for the uncertainty of the markets. But it is not. Here's why.
First, the S&P 500's return over the past 10 years was 6.34%. So even in some of the worst markets in recent history, the return of the S&P 500 was better than the perceived return of this guaranteed annuity.
Second, the annuity does not have a 6% return, even if the Jeffersons lived forever. Buying an annuity begins with the immediate loss of 100% of your original investment. So for the first 15 years, the annuity company is simply giving you back your original purchase price. The way most salespeople describe thinking about the annuity discourages investors from realizing that their original money is gone forever. They do this by referring to it as an investment. I would not call it an investment because after you purchase an annuity, your principal no longer has any value.
The entire selling point of the annuity is a lower return in exchange for a guarantee. But when analyzed, the purchase price is a loss you can never recover from. We can analyze this annuity purchase like an investment and calculate an internal rate of return (IRR). For the first 15 years, the IRR is 0% because the annuity company simply hands you back your own money.
If Thomas and Martha die after 16 years, the IRR would be 0.92%. If they live to age 85, after 23 years the IRR will finally have risen to 3.47%. If they both live to be 100, the IRR would still only be 5.57%. Even if the Jeffersons lived forever, the IRR couldn't exceed 6% because they lost their original $500,000.
Third, immediate annuities are not indexed for inflation. Part of their appeal is having at least some stream of guaranteed spendable income, but guaranteed to buy what? This annuity quote is for a fixed payment of $30,000. The payment is fixed in dollars whose buying power diminishes by inflation every year.
According to the government consumer price index (CPI), $5,081 in 1970 had the same buying power as $30,000 today. Imagine thinking you had your future retirement needs guaranteed in 1970 by buying an immediate annuity paying $5,081. An annuity is supposed to be longevity insurance. But now at 104 years old, you are trying to live off a sixth of what you needed when you began your retirement.
The only real guarantee of an annuity is a diminishing lifestyle because of inflation. We use 4.5% as an average inflation rate. By the time Martha is 85 years old, inflation will have reduced the buying power of the annuity from $30,000 to less than $11,000.
Annuities offer too much income to spend early in retirement only to keep that number constant and offer too little later in life. This math error is part of their mistaken appeal to the public. We would suggest that the safe spending rate for a couple with $500,000 is only 4.17% at age 62. This would limit their annual safe spending to $20,850.
But with an appropriate asset allocation and this rate of spending, the Jeffersons would have a good chance most years to enjoy an increase in their spending allowance greater than inflation as their assets appreciated. And any unused assets could be left as an inheritance for their heirs.
Finally, I've used the example of a 6% or $30,000 annuity, but the best quote I was given for my sample couple was $27,569. And the quote for an annuity tied to the urban consumer version of the CPI index was for $15,814.
We don't recommend an allocation to annuities for any portion of your portfolio. We believe an age-appropriate allocation to bonds provides a similar boost to the likelihood you will have sufficient assets in retirement. We suggest allocating five to seven years of safe spending in stable investments with the remainder in appreciating assets.
Coupled with staying within an age-appropriate safe spending rate, this strategy provides the best balance between sleeping well tonight and eating well in 10 years.
Ever-popular annuities sometimes sound too good to be true, which in itself is probably a good reason to avoid them.
An annuity is a financial product sold as a way to collect and grow funds and then later receive those funds as a steady cash flow during retirement. Annuities have many flavors and features that vary this basic principle, but the basic terms you will hear are "deferred or immediate" and "fixed or variable."
A deferred annuity puts off taking withdrawals, whereas with an immediate annuity you can take withdrawals right away. A fixed annuity has a preset withdrawal amount that does not adjust for inflation. A variable annuity is tied to the performance of some investment choices.
Commission-based advisors with insurance licenses sell you whatever form of annuity would have performed well over the past decade. They say they are fee-based, at least partly to sound more like fee-only financial planners. If you are confused by these distinctions, then 93% of the financial services world who can't call themselves fee-only are doing their jobs well. You do well when you remember that fee-based is not the same as fee-only.
Let's review the math behind an immediate fixed annuity. This type of annuity receives a fair amount of seemingly scholarly press trying to justify including this product as part of a balanced portfolio.
Imagine that Thomas and Martha Jefferson, ages 64 and 62, respectively, purchase an immediate annuity that will pay them a guaranteed 6% annual return. If they have $500,000, they would receive $30,000 every year for the rest of their lives. This income, added to their Social Security, would comprise the spending for their lifestyle.
This scenario sounds fair. After all, who wouldn't want to have earned 6% over the last 10 years during these mixed markets? Earning 6% guaranteed feels like a good exchange for the uncertainty of the markets. But it is not. Here's why.
First, the S&P 500's return over the past 10 years was 6.34%. So even in some of the worst markets in recent history, the return of the S&P 500 was better than the perceived return of this guaranteed annuity.
Second, the annuity does not have a 6% return, even if the Jeffersons lived forever. Buying an annuity begins with the immediate loss of 100% of your original investment. So for the first 15 years, the annuity company is simply giving you back your original purchase price. The way most salespeople describe thinking about the annuity discourages investors from realizing that their original money is gone forever. They do this by referring to it as an investment. I would not call it an investment because after you purchase an annuity, your principal no longer has any value.
The entire selling point of the annuity is a lower return in exchange for a guarantee. But when analyzed, the purchase price is a loss you can never recover from. We can analyze this annuity purchase like an investment and calculate an internal rate of return (IRR). For the first 15 years, the IRR is 0% because the annuity company simply hands you back your own money.
If Thomas and Martha die after 16 years, the IRR would be 0.92%. If they live to age 85, after 23 years the IRR will finally have risen to 3.47%. If they both live to be 100, the IRR would still only be 5.57%. Even if the Jeffersons lived forever, the IRR couldn't exceed 6% because they lost their original $500,000.
Third, immediate annuities are not indexed for inflation. Part of their appeal is having at least some stream of guaranteed spendable income, but guaranteed to buy what? This annuity quote is for a fixed payment of $30,000. The payment is fixed in dollars whose buying power diminishes by inflation every year.
According to the government consumer price index (CPI), $5,081 in 1970 had the same buying power as $30,000 today. Imagine thinking you had your future retirement needs guaranteed in 1970 by buying an immediate annuity paying $5,081. An annuity is supposed to be longevity insurance. But now at 104 years old, you are trying to live off a sixth of what you needed when you began your retirement.
The only real guarantee of an annuity is a diminishing lifestyle because of inflation. We use 4.5% as an average inflation rate. By the time Martha is 85 years old, inflation will have reduced the buying power of the annuity from $30,000 to less than $11,000.
Annuities offer too much income to spend early in retirement only to keep that number constant and offer too little later in life. This math error is part of their mistaken appeal to the public. We would suggest that the safe spending rate for a couple with $500,000 is only 4.17% at age 62. This would limit their annual safe spending to $20,850.
But with an appropriate asset allocation and this rate of spending, the Jeffersons would have a good chance most years to enjoy an increase in their spending allowance greater than inflation as their assets appreciated. And any unused assets could be left as an inheritance for their heirs.
Finally, I've used the example of a 6% or $30,000 annuity, but the best quote I was given for my sample couple was $27,569. And the quote for an annuity tied to the urban consumer version of the CPI index was for $15,814.
We don't recommend an allocation to annuities for any portion of your portfolio. We believe an age-appropriate allocation to bonds provides a similar boost to the likelihood you will have sufficient assets in retirement. We suggest allocating five to seven years of safe spending in stable investments with the remainder in appreciating assets.
Coupled with staying within an age-appropriate safe spending rate, this strategy provides the best balance between sleeping well tonight and eating well in 10 years.
I have always heard that annuities were not wise to have but I have never seen this explain in such simple terms.
Posted by: Matt | September 15, 2012 at 07:21 AM
Annuities are fixed and guaranteed. They remove the risk of outliving your savings. Thats the point. They aren't supposed to get you the highest return. For high returns you have to take risks. Like in the risky, volatile stock market. Putting ALL your money in the stock market at retirement has high risk and a reasonable chance you will outlive your funds even at the conservative 4% withdrawal rate.
"the S&P 500's return over the past 10 years was 6.34%"
Not much to brag about given the risks. When was that 10 years any way? From 2001 to 2011 the S&P 500 had annual returns of 3.4% and compound annual growth of 1.4%. And from 2000 to 2010 the S&P 500 had a compound annual growth rate of -2%.
Whats the return of having age appropriate bonds investment and 7 years of spending in safe assets over the past 10 years??
If you have a giant pile of money then theres no need for annuities. You can sit on your millions and take the risk in the stock market. For many retirees an annuity for a portion of your assets to guarantee a base level of income can make sense as it removes the risk of retirement planning and gives you a guaranteed fixed income for life.
Yes most annuity quotes are not inflation adjusted. Thats a good point many people don't realize. But you can of course buy an annuity with inflation adjustment and doing so can make sense. You pay around 20-30% more for that from what I've seen.
If the 'safe' withdrawal rate of 4% would turn your $100,000 into a $4000 annual income flow then an fixed annuity with guaranteed income of $4500 inflation adjusted for life of a married couple isn't a rip off.
Again if you're a multi-millionaire then theres no need. If you are a typical retiree with a limited retirement fund then it can make some sense.
I don't want to over hype annuities but fixed immediate annuities are not a rotten deal in general. The return on investment is not particularly high especially given todays low interest rate environment.
Posted by: jim | September 15, 2012 at 12:49 PM
I have to disagree and I was a financial planner for 16 years. I sold MYSELF a deferrrd VARIABLE annuity with a large, high rated insurer. Why? To "guarantee a lifetime income" without annuitization. As a piece of MY portfolio (all the tax deferred monies that make up about 1/4-1/3 of my net worth) I will nevr lose a cent (principal guarantee), can get a stream of income at a 7% withdrawal rate FOREVER, even if the contract value goes to ZERO (!!), and I participate in market returns with the most aggressive portfolio the contract allows a 75/25 equity/income split. Are annuities expensive? YES. But, are some costs in life worth the products quality and peace of mind? I think so. Investing this money when the S&P was at 1525 has allowed me to not see any principal loss over 4 years and my income when I decide to use the lietimne guarantee rider can't drop. Only rise. Forever. I like that! Since tax deferred monies are ordinary income taxed anyway, it does make sense that IRA monies, etc., be invested in such a product at about middle age, if the product fits the situ! For many folks it does.
Posted by: Jeffinwesternwa | September 15, 2012 at 07:30 PM
I agree, and understand most of the article here. I'm still curious what 10 year recent period showed 6%+ for the S&P. This a mistake or a typo?
Posted by: Joetaxpayer | September 15, 2012 at 09:41 PM
Joetaxpayer: http://dqydj.net/sp-500-return-calculator/ plug in 10 years (it's actually the default in the form) and look at the "Annualized S&P 500 Return (Dividends Reinvested)" field.
Posted by: Mr. Cheap | September 15, 2012 at 10:36 PM
Well as of 8/31/2012 the 10 year return of the S & P has returned over 6%. Funny how we get so myopic about the "lost decade" that many fail to recognize when markets return to the mean.
Jeff in WesternWA timed the market pretty well and got in on one of the best riders available. Won't find one near that favorable today. His assertion that his income won't go down when he activates the rider is questionable at best. When you get a flat rate of return (whether it is 3% or 7%) you are faced with a loss of purchasing power due to inflation.
Also the likelihood of a market based rise in income once he turns it on is slim. Since they deduct the expenses, your distribution and you must overcome the 25% bond split you will need to do somewhere north of 11% in the market the first year to see any raise. Each year that goes by makes it even more unlikely.
The biggest issue with these annuities is that although you technically don't annuitize and lose control of your money, the insurance company drains your account pretty quickly with expenses and once your balance gets to zero who cares who has control.
Posted by: Mike | September 16, 2012 at 09:09 AM
Forgot to mention one other issue with these "market lock" or "step up" annuities. Many of them calculate the rider fee based on the "income credit base" rather than the account value. The "income credit base" is not real money but goes up every year prior to taking income. Thus, they drain the account value even quicker than most realize. Many of the people selling these products are unaware of this. Of the few who are aware of it, most don't disclose this issue.
Posted by: Mike | September 16, 2012 at 09:22 AM
The S&P500 return from 9/14/2002 to 9/14/2012 is now at ANN=5.11%.
Posted by: Old Limey | September 16, 2012 at 11:05 AM
Well now we have solved the great mystery of those fateful souls who invested on 9/14/2002 and liquidated on 9/14/2012. Always wondered what happened to them!!!
Posted by: Mike | September 16, 2012 at 12:25 PM
It is interesting to note the similarities with the UK annuity market. Over here we have seen annuity incomes plummet over the past 12 months, down by an average of 8.6% since January. It is true that as an investment opportunity, seniors are barely getting their money back when buying an annuity - and as you mention it takes 15 years just to get back what you invest (16 years 9 months in the UK btw).
However annuities DO provide a guaranteed income for life, so you will never run out of money in retirement. The problem is I think an increasing number of retirees will not be swayed by this argument. They save hard their whole lives only to presented with woeful returns from their annuity provider.
Posted by: Simon | November 08, 2012 at 01:02 PM