Everybody hates life annuities except economists, but economists love them.
Most people don’t like the idea of handing a big chunk of their
savings to an insurance company in exchange for the promise of a lifetime of
monthly payments when that lifetime could end right after they sign the
contract.
A client and his
wife asked me for retirement advice a few years ago. I barely got out, “Hello.
. .” when the wife said, “And don’t tell us about annuities. My sister bought
one and died two years later.”
It was clear that
would be the end of any discussions regarding life annuities. A lot of people
feel that way.
Economists, on the
other hand, don’t seem to understand how anyone in their right mind could pass
up the opportunity to insure that they won’t die broke if they live to a ripe
old age.
I am fully in the
camp of economists when it comes to retirement planning, the alternative to be
in the camp of those who sell stocks for a living. On this one topic, however,
I part ways with most economists. I don’t like life annuities, but not for the
reasons most people say they dislike them.
You can get around
the problem experienced by my client’s sister by purchasing an annuity contract
that promises to return your investment in the event of an early death. Still,
life annuities are a tough sell. You lose control of your capital with a contract
that is difficult to understand and harder to undo.
But there are two
other problems with life annuities that bother me more. First, you can’t know
how much a life annuity will cost until the time comes to purchase one. Their
prices are largely determined by your age at the time of purchase and interest
rates at the time of purchase.
“I’m about to
retire,” a client recently told me. “Should I go ahead and buy a life annuity
now?”
“Probably not,” I
explained.
You see, the thing
about immediate annuities is their immediacy.
My client wanted to buy an annuity today that would begin paying
out a pre-determined income in fifteen or twenty years. We’d all like to buy
one of those, but no one will guarantee you payments today to begin several
years from now because they don’t know what interest rates will be then or how
much inflation we’ll experience. If you buy an immediate fixed “life” annuity
today, you must begin receiving payments in less than a year.
My client wants to
retire in his late fifties and a life annuity beginning at that relatively
young age would be extremely expensive, plus it would lock in today's low
interest rates. That’s a terrible time to buy.
The younger you are when you purchase a life annuity, the more the
annuity will cost because the insurance company will probably have to pay you
for a longer time. It "costs more" in the sense that it pays out less
for the same contract amount.
With immediate
fixed annuities, you more or less have to keep shopping for one until it
"goes on sale", meaning you're probably around 70 years old and long term
interest rates are sufficiently high. That makes life annuities a very
difficult tool for planning.
How much
difference can interest rates make? Several years ago, I priced out an annuity
that would pay $1,000 a month for the rest of my life beginning at age 65 and
$500 per month to my wife if she survived me. At that time, had I been 65, I
could have purchased the annuity for about $113,000.
Recently, in this
time of extremely low interest rates, I priced the same annuity and was quoted
a price of $240,000.
Let me express
that another way. Several years ago, $1 per year of income beginning at age 65
and paid for however long I might live with the 50% survivor’s payout would
have cost me $9.42. Today, that same $1 per year of income would cost me about
$20.00.
The cost of a
lifetime annuity, like the price of bonds, moves opposite interest rates. If
interest rates go up, life annuities pay more (they’re cheaper) and vice versa.
That’s because insurance companies use bond interest they earn to make annuity
payments.
The same is true of alternative investments, of course. When
interest rates are low (as they are now), it isn't a good time to buy bonds for
future income, either. There just isn't a good way to purchase retirement
income when rates are low. You need to wait. And that means being reactive instead of planning.
Interest rates are
unpredictable and they can make a huge difference in the cost of an annuity, so
I can’t plan my retirement finances or yours using life annuities. If you ask
me how much monthly income you can receive if you use your retirement savings
to purchase a life annuity, I can’t tell you unless you plan to purchase it
pretty soon.
The second problem
I have with life annuities is inflation. Most life annuities pay income in
nominal (inflated) dollars. A few companies offer contracts with inflation
protection, but it is extremely expensive. You should expect it to be, because
guaranteeing inflation rates for thirty years or more is very risky and you’re
paying the insurance company to transfer that risk from you to them.
The ideal retirement income investment would generate a steady, predictable income from the day we retire until the day we die, even if that turns out to be 40 years, and it would be affordable. At first glance, a life annuity seems to do that, assuming interest rates are high enough at the time you purchase the annuity for it to be considered “affordable”. Here’s what income looks like for a nominal annuity, i.e., one without inflation protection:
The ideal retirement income investment would generate a steady, predictable income from the day we retire until the day we die, even if that turns out to be 40 years, and it would be affordable. At first glance, a life annuity seems to do that, assuming interest rates are high enough at the time you purchase the annuity for it to be considered “affordable”. Here’s what income looks like for a nominal annuity, i.e., one without inflation protection:
(Click on any of these graphs to enlarge them.)
How bad can inflation be over thirty years? Pretty bad, as it turns out. The following chart shows what would have happened to the purchasing power of $1.00 over 67 rolling thirty-year periods beginning with 1915-1944 and ending with 1981-2010.
In the best case (1921-1950), $1.00 still bought $0.75 worth of goods after thirty years. That’s the top line at the far right of the graph and it averages just less than 1% inflation per year. But in the worst case (1968-1997), it bought only $0.18 worth of goods after 30 years of inflation averaging 5.6% per year. (The lowest line on the right side of the graph.)
The thick, red
line shows the median value of $1 for each of the thirty years across all
periods. The median nominal $1 was worth about $.32 after thirty years. Those
lines that go above a dollar on the chart, like the blue one I pointed out, are
a result of deflation in the 1920’s and 1930’s. If you believe that deflation is
unlikely to repeat and you begin the chart in 1940, then the median nominal
dollar falls to $.26 over thirty years.
These are the real
dollar outcomes you would have received from a nominal annuity. I’ll add a
thick blue line, just for emphasis, to remind you what retirement income we “desire”,
which is also the payout pattern of a nominal annuity. You can compare our
desired-income/nominal-annuity-income to the real income we would have
historically received.
The gray lines
indicate the best and worst inflation, so I can remove the historical data in
between and simplify the graph.
The red line doesn’t seem to be
what we’re looking for, does it?
When you consider
real dollars (in red) as opposed to inflated dollars from a nominal annuity (in
blue) — and that should be the real consideration for a retiree — nominal
annuities are a poor fit to the ideal investment I charted in the first graph.
As I mentioned,
inflation-protected life annuities can be purchased, though they aren’t cheap.
I recently priced a life annuity for a 65-year old male with no inflation
protection and another with inflation protection. The payout for the former was
5.84%, meaning it would pay $5.84 (nominal) for every $100 of annuity I
purchased. The latter would pay just $3.88, but that amount would be adjusted
to compensate for inflation over time.
Said differently,
I could receive $1.00 of income in year one, whose purchasing power would
decline with inflation through the years, or I could receive $0.66 of income in
year one for the same price and its purchasing power would remain constant
throughout the remainder of my life.
Now, let’s add the
purchasing power of that inflation-protected life annuity to the chart above.
The thick black line represents the inflation-protected (real dollar) income I
could purchase for the same price as a nominal annuity based on those two
recent quotes.
What does this
chart tell us? First, the inflation-protected annuity income (black) matches
our “desired income” (blue) distribution pattern, but not its value. It’s 33% less to begin
with. After about 10 years, though, it
comes closer to what we desire than
the nominal annuity does.
Second, inflation
protection is expensive. In the median historical case, it took about 10 years
for the inflation-protected annuity to catch up with the nominal annuity. But,
if those were my only two choices, I would still purchase inflation protection.
Why? Because I
would buy an annuity as insurance against running out of purchasing power in the
event that I live a long time. A nominal annuity doesn’t usually provide
that insurance after 15 or 20 years nearly as well as an inflation-protected
annuity. The nominal annuity is a lot cheaper, but I don’t go to the
hardware store needing a shovel and buy a rake, instead, because it’s cheaper.
Besides, if I
thought I would only live ten years or less, I wouldn’t purchase any kind of annuity. Live longer than 20
years and the inflation-protected annuity always wins.
Life annuities
without inflation protection do a very poor job at exactly what we want them to
do — provide purchasing power if we live a long life. In fact, the median
nominal annuity pays about 60% of its purchasing power in the first 15 years
and only 40% in the last 15 years, the period you are trying to insure.
An
inflation-protected annuity is better than a poke in the eye with a sharp
stick, but these aren’t my only choices and I still don’t like annuities.