Immediate fixed income annuities

[Bill J.]

OK, here's something I don't understand--hopefully one of you can give me some advice.

I've read that the SWR is about 4%. If I can buy an income annuity that is fixed-rate at 4% (or higher) and is inflation protected, why not do that and let someone else be responsible for managing at least part of the nest egg? I'm not a good money manger in general, and it would be a relief to have some help with something this important to my future.

I know annuity rates are low right now so I probably should wait a while, but what about this general idea?

 

[cute fuzzy bunny]

That works great if you have a big enough nest egg that the 4% is enough to live on, including buying new cars, fixing the house, replacing appliances, paying for babies that come out of nowhere, etc.

However, note that annuities wouldnt exist if the issuer wasnt making money, and by investing in the same sorts of instruments they invest in, you can cut out the middleman.

Didnt I see something that said that most annuities give you quotes based on average returns of a 20/80 TSM/TBM type mix?

 

[charlie]

Bill,

I am 70 and am playing with the idea myself. Vanguard
has an annuity quote calculator on their website:

http://flagship3.vanguard.com/web/corpcontent/scatSvcsAnnuitiesOV.html

I plugged in $100,000 investment and got $399.59 per
month, joint life with 20 year guarantee, 3% annual
COLA. Without the COLA, the monthly was $571.96.
You can get the COLA in 1% increments up to 5%.

As you can see, the COLA amount breaks even in
about 11 years but takes roughly 20 years to recover
the higher monthly of the non-COLA. $399.59 amounts
to 4.8% on the initial investment while $571.96 amounts to 6.86%.

The downside of course is that you lose control of your
money and leave nothing for your estate if you and your
wife live past 20 years. The upside is guaranteed income for life.

The idea has a seductive allure for me but I would not
commit the ranch to it. Maybe just enough to cover
bare bones living expenses with a COLA. Still pondering
and waiting for rates to go up.

Cheers,

Charlie

 

[ESRBob]

Chuck-Lyn,
With your 'headstart' on us, I think you'll find the annuity payments become tempting. If an annuitant is in his or her 40s the payouts are smaller -- nothing personal they assure us -- just actuarial tables!

I ran some annuity numbers for my inlaws who are your age, and they were on the fence, and what made them stay put was the idea of 'losing their principal'. I suppose I should be grateful that leaving something to my wife and kids is enough of a priority for them that they will take their chances with a traditional SWR approach. Still it is sometimes easy to forget that at the end of the day, an annuitant forks over the cash for good, whereas the SWR person milks the cash out of the portfolio, and still has a pretty good shot of having the principal intact (at least) at the end of his life.

ESRBob

 

[charlie]

The thing I keep coming back to is that it does not have
to be an all or nothing deal. If I converted my IRA,
which is 2/3 of our total stash, it would produce a
little more than I am drawing now (roughly 6%), but
without a COLA.. This is enough to cover living expenses now. That leaves 1/3 to grow and provide
coverage for inflation and leave an estate. We also
have a home worth about $250k which would give
the kids a nice boost in 20-30 years.

Part of it is a male hormone thing ....... I hate to give up
control. But, the sad fact is that Lyn's eyes glaze over
at the thought of managing a portfolio. She would be
better served with an annuity if it comes to pass that I
need a drool cup prematurely. We still have a few years to let it ride, hopefully. But, if annuity interest rates rise significantly, I will be sorely tempted.

Cheers,

Charlie

 

[Bob_Smith]

Charlie, you've delved into annuities so maybe you know. Is there a way to determine the value of a non-COLA'd pension that won't start for another three years? I'm just ball-parking it and would like to get closer. I can use Vanguard's calculator, and this one: http://www.immediateannuities.com/ to get what the cost would be within about a year - but how much would you knock off the price for delaying the payments until May 2007? All of the payments for those three years? Half?

 

[charlie]

Bob_Smith,

I haven't given your question any thought until now.
The amount annuities pay is determined by your age,
the state and prevailing long term rates at the time you
buy the annuity. Adjustments are made if it is a joint
annuity, if there is a guaranteed payout period and if
there is a COLA. I suppose you could play with the
age input to get an estimate for today's rates. You
might also check out the 72t(t) annuity type calculation
which accounts for expected life and interest rates.

Other than that, I have no clue.

Cheers,

Charlie

 

[Hyperborea]

Is there a way to determine the value of a non-COLA'd pension that won't start for another three years? I'm just ball-parking it and would like to get  closer. I can use Vanguard's calculator, and this one: http://www.immediateannuities.com/ to get what the cost would be within about a year - but how much would you knock off the price for delaying the payments until May 2007? All of the payments for those three years? Half?

This sounds to me like you would use the present value (PV) calculations in two steps.  First calculate the PV of the pension using the formula for the series of payments for a number of periods.  This calculation assumes that the payments are made at the end of each period (ordinary annuity).  You can look up the formula for the case where the payments are at the start of each period (annuity due).  If you do this monthly the differences between the values either way will be small.

PV1 = C * (1 - (1 + i)^-n)/i
C - payments
i - interest rate (discount rate that you want to use for the future pension payments - probably at least inflation and maybe the amount that you could earn in CDs?)
n - number of payments (guess at a reasonable life expectancy - as the periods go long the error will be small as the contributions of periods far in the future are very small)
Make sure that i and n match.  In other words if you use months for n then make sure that i is a monthly interest rate.

Now you need to take that present value, PV1, and push it 3 years into the future with the lump sum PV calculation.  That would give:

PV2 = FV / (1 + i)^n

In this case the values for the variables are:
FV = PV1
n = 3
i = discount rate (see above)

PV2 = PV1 / (1 + i)^3

There might be some simplification on the symbolic side that could be done but it would be just easier to grind the numbers.

 

[Bob_Smith]

Hyperborea, thanks for the formula.

 

[Michael]

If I can buy an income annuity that is fixed-rate at 4% (or higher) and is inflation protected, why not do that and let someone else be responsible for managing at least part of the nest egg?

Older investors can increase their SWR by using annuities.  Younger investors don't gain much, if anything.  Younger investors also give up any chance of a rise in real income over time from potential portfolio growth.  It is especially important for younger retirees to get a genuine inflation adjust.  If a young retiree opts for a flat 3% adjust per year, they could lose big time if inflation returns to the double digit pace of the 70s.  For younger retirees, there is also the danger that the insurance company you buy the annuity from could go bankrupt over the next 40 years or so. You never know what will happen in the future.