Tuesday, March 19, 2013

Everybody Hates Annuities


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:


(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.

4 comments:

  1. Thanks so much for sharing this. I have been looking into if I should sell my annuity or not. I have had some student loans to pay off so I think that I definitely should.

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  2. Before you sell, make sure you understand the implications. If you owe student loans, I assume you are relatively young. If so, and your annuity has no inflation protection, payments in your distant future will likely be heavily devalued by inflation. On the other hand, annuity sales can trigger surrender charges and income taxes, so make sure you understand both of those before you sell. Lastly, the one time I considered selling an annuity, the buyer was offering ridiculously low prices. It's a complicated transaction, so make sure you understand all of the implications of taxes, transaction costs and inflation risk. And good luck. I'm glad you found my blog helpful.

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  3. I have a TIAA-CREF pool of money in a traditional annuity account, which has to be annuitized over at minimum of 10 years but can be annuitized over my lifetime if I so choose. In the meantime, each monthly deposit that was made over a span of 11.5 years to create this pool of money continues to earn the interest rate that was in effect at the time it was deposited, with the total pool earning nearly 4.4% per year. I am 66 years old. If I annuitize now over my lifetime I will receive $700 per month; if I annuitize now over a period of 10 years, I will receive 10 payments of approximately $13,000. There is no real inflation protection option. I need longevity protection, but do you think I would be better off taking the 10-year payout and using the payments to buy TIPS for inflation protection? I can afford to wait to age 70 1/2 to annuitize, but that doesn't increase the monthly payout much (to about $870), and if I annuitize now I decrease the risk of dying before getting back my principle.

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  4. Hi, Flora. Without knowing the rest of your financial situation, I can't provide specific advice, but here are a few thoughts.

    4.4% is a lot higher than what you can earn today. Buying TIPS today would lock in a much lower yield. With inflation currently running about 0.8%, that yield looks pretty good and provides some inflation protection. Social Security benefits are also protected against inflation.

    I would think that your greatest risk is outliving your savings, which far outweighs the risk that you might die before you get your principal back. I would argue that getting your principal back shouldn't be a consideration, at all. Outliving your savings would be a far worse outcome financially. The annuity, along with Social Security benefits will help you avoid that worst-case scenario.

    I can imagine reasons why you might go with TIPS bonds, such as your having saved more than you need for retirement, but based on the limited information you have provided, I would strongly consider annuitizing at 70 1/2 to maximize your income if you live a long time.

    Good luck, and thanks for writing!

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