Why Don't Retirees Buy Annuities? They Get Something Most Economists Don't

[Kimo]

I am quite happy with my Vanguard annuities. They operate quite differently and might be worth a look...

 

[haha]

+1. But that risk exists with long bonds (& funds) as well. Locking in to a ~4-5% yield, even assuming holding safe indiv long bonds to maturity, risks a huge loss of purchasing power over time if inflation goes back to double-digits (as too many of us can recall ).

You are certainly correct, and I agree. But a big difference is if you get suspicious getting rid of the bond funds is a keystroke and a small commission away. For this reason I think a commitment like a SPIA is categorically different, and inferior, to other fixed income possibilities. In any case, a 5 year duration would be a long time for me. I've had some intermediate term bond funds with effective durations mostly between 3 and 4. I bought them at higher quotes than today, but even with weak price action over the last 6-8 months I am still well ahead of any cash type investment.

Ha

 

[brewer12345]

TIAA CREF offers a SPIA that I need to really dig into when I have time. It is a payout annuity that gives you the option of having the underlying assets in either the insurer's fixed account (general account) or several variable account options (including equity indicies). I am guessing that the product separates the investment risk fro the longevity risk, with the longevity risk born by the insurer and the investment risk born by the policyholder. I need to poke at this thing to really understand the mechanics of it and no doubt it is expensive, but it might offer an option for a SPIA that fives some options to allay inflation risk.

 

[thanp73]

Could you give a link to a reputable broker of these things? I know they must exist, because my free UHF TV channels always feature ads offering to take those pesky annuities or structured settlements off people's hands.

BTW, I think annuities have a giant elephant in the room risk that rarely gets deeply considered. A person does not have to be crazy to expect a humdinger inflation at some point near or far in our future.

Ha

Link sent via PM

RE inflation- agreed 100%. inflation is a concern that must be addressed, and an annuity is not going to solve it. neither are bonds, or stocks in a general sense, or any broad answers. certain stocks, yes... certain right pieces of real estate with resilient tenants, yes... certain metals, maybe...
there is no broad brush answer we can have today for all the multitude of things that MIGHT happen tomorrow. nor is what MIGHT happen tomorrow a reason for not doing something right today. Just be prudent.

 

[thanp73]

Not necessarily true.

We have a joint/life guaranteed term SPIA and it was very easy to calculate the base IRR. Simply plug in the premium, the total annual payments, and the number of term/years (cells) on a spreadsheet.

We know the minimum return, since our guaranteed term (either we get paid, or our estate does) establishes a minimum period of payments.

And if either/or live beyond the minimum term (calculated at 28 years for us)? The calculated return actual rises.

We can't outlive our SPIA; however if our SPIA "outlives" us, there is residual value that goes to our estate.

As far as IRR vs. payment? You are correct; IRR must be computed for any SPIA product in order to make correct comparisions. Also, folks forget that an SPIA is an income product, not an investment product. It's not there to make you money but rather an instrument in your retirement toolbox to provide you with distribution of investment proceeds over a period of time. That's why our current SPIA was purchased with only 10% of our then current joint portfolio value at retirement (early 2007). The remaining 90% of our portfolio stays invested (relative to our AA) and does the heavy lifting for the future.

I think you got my point, that the ending final IRR of your SPIA can only be calculated after it's done paying. hopefully that's well more than 28 years.

The guaranteed IRR, depending on when you bought it, was most likely in the 1.5 to 2.5% range, which is not really a very competitive return.

As with most annuities, they really should not be considered 'investment' products because they are truly 'insurance'. You're buying some level of insurance with the premium, which ALSO happens to have some (restricted) returns. In the case of your SPIA, the insurance comes into play in yours after 20 years, and the first 20 year guarantee is simply a protection of your assets for your heirs.

 

[Kimo]

I really think this applies to the "insurance" products. I do consider mine an investment because the entire annuity amount is in the Wellington mutual fund which I also own in my regular brokerage account....same funds.


"As with most annuities, they really should not be considered 'investment' products because they are truly 'insurance'. You're buying some level of insurance with the premium, which ALSO happens to have some (restricted) returns. In the case of your SPIA, the insurance comes into play in yours after 20 years, and the first 20 year guarantee is simply a protection of your assets for your heirs."

 

[aja8888]

I think you got my point, that the ending final IRR of your SPIA can only be calculated after it's done paying. hopefully that's well more than 28 years.

The guaranteed IRR, depending on when you bought it, was most likely in the 1.5 to 2.5% range, which is not really a very competitive return.

As with most annuities, they really should not be considered 'investment' products because they are truly 'insurance'. You're buying some level of insurance with the premium, which ALSO happens to have some (restricted) returns. In the case of your SPIA, the insurance comes into play in yours after 20 years, and the first 20 year guarantee is simply a protection of your assets for your heirs.

Especially when you can lock in 3% at PenFed in an insured 5 year CD and get to keep your principal.

 

[Chuckanut]

BTW, I think annuities have a giant elephant in the room risk that rarely gets deeply considered. A person does not have to be crazy to expect a humdinger inflation at some point near or far in our future. Ha

Very true. Can one reduce the inflation risk by purchasing smaller annuities over time instead of a bigger one at one time? I assume if inflation should jump to 10+ percent for any length of time the new annuities would pay more for the same amount of dollars invested. Or not? My annuity, FWIW, is getting SS at 70. And having a chunk of my assets in PSSSTTT Wellesly. Diversification of income sources is still high on my list of investment rules.

 

[2B]

Here's a link to a Retire Early article that has some insights into SPIAs.

Some really bad annuity advice from Dr. Lew Mandell.

I've always felt that variable annuities are an offense against God. SPIAs are just usually a bad deal for most people. Some people here take great comfort in them but I've seen my in-laws annuities (both VA and SPIA) in action. SPIAs after a couple of decades look pretty pathetic even though it paid quite a tidy sum when originally purchased. That convinced me I'd rather have my money.

As for when to buy a SPIA, I'd say it's worth looking at if you are 70 years old and in excellent health. Then, it's reasonable to get a quote. If it looks interesting, don't buy then but reevaluate it again at 75. Repeat as necessary.

 

[pb4uski]

While I would agree that Mandell is off-the-wall, I would object to the notion in the Money's Worth Ratio that a ratio of one (where the premium equals the expected present value of contractual benefits using the investment earnings rate of the assets backing the annuity) as being "actuarially fair". A ratio of one would be skewed to the purchaser of the annuity.

To be fair, the calculation needs to consider at least two additional items, only one of which is mentioned in the book. First are expenses of the issuer, including marketing, commissions, and other expenses of running the block and a fair share of overhead costs of the issuer. Second, and more important, is the cost of capital of supporting the block. Unlike a mutual fund, an insurer needs to hold assets in addition to those backing the annuity reserves and the providers of that capital expect a fair return on it. That capital is at risk if actual mortality for the block is lower than what was provided for in pricing the annuity and benefits payments are more than what was priced for.

As a result of the need for pricing to cover expenses and cost of capital in addition to providing for annuity benefits, the notion if a money value ratio of one being fair is bunk.

 

[rescueme]

The guaranteed IRR, depending on when you bought it, was most likely in the 1.5 to 2.5% range, which is not really a very competitive return.

IRR calculated at 4.79% over 28 years.

 

[pb4uski]

When did you buy it? Quite a while ago when interest rates were higher?

 

[rescueme]

Especially when you can lock in 3% at PenFed in an insured 5 year CD and get to keep your principal.

The problem is now you have an investment vehicle. It only makes sense if you can live on only the interest the CD is throwing off.

You can't withdraw any of your initial investment; you can only get the interest generated (monthly/quarterly).

An SPIA will generate a consistant stream of income, regardless of the amount (premium) that still remains to be invested. With a CD, your principal needs to stay invested for the full term, while an SPIA's "principal" (premium) is constantly reduced over time.

Again, don't confuse an SPIA with an investment vehicle. They are two different products; one to manage income, the other to manage gains.

They are two different "animals" .

Our SPIA was funded with gains from our "regular" investments (e.g. portfolio). It's use is to manage the long term distribution of those gains, with minimum risk, over a period of time.

Our joint portfolio continues to generate gains for future distributions, be it by direct withdrawls or under a managed vehicle, such as an SPIA.

 

[rescueme]

When did you buy it? Quite a while ago when interest rates were higher?

July, 2007. I/DW were both age 59 at that time.

And we considered the low interest rates at that time as a risk ...

Goes to show that you never know what the future will bring, regardless of the current environment...

BTW, the SPIA was purchased at an earlier age than most folks would recommend, but then again we purchased it for a different reason. While retiring earlier than planned, I had no pension from my megacorp. In addition, we had a desire to delay SS until at least our respective FRA ages (next month for me; May for DW).

It worked out so well that we will now be both delaying SS till age 70 - an unexpected benefit that was not realized until we put our plan in motion.

As far as SS? I'll be doing a file/suspend next month, after my birthday. DW will do a restricted application and claim 50% of my benefit starting in May (June payment).

 

[imoldernu]

Just re-read the thread...
Annuities?
Hmmm... At this age, we don't buy green bananas.

 

[haha]

While I would agree that Mandell is off-the-wall, I would object to the notion in the Money's Worth Ratio that a ratio of one (where the premium equals the expected present value of contractual benefits using the investment earnings rate of the assets backing the annuity) as being "actuarially fair". A ratio of one would be skewed to the purchaser of the annuity.

To be fair, the calculation needs to consider at least two additional items, only one of which is mentioned in the book. First are expenses of the issuer, including marketing, commissions, and other expenses of running the block and a fair share of overhead costs of the issuer. Second, and more important, is the cost of capital of supporting the block. Unlike a mutual fund, an insurer needs to hold assets in addition to those backing the annuity reserves and the providers of that capital expect a fair return on it. That capital is at risk if actual mortality for the block is lower than what was provided for in pricing the annuity and benefits payments are more than what was priced for.

As a result of the need for pricing to cover expenses and cost of capital in addition to providing for annuity benefits, the notion if a money value ratio of one being fair is bunk.

I should start by saying that this critique and the Money's Worth Ratio is the most useful thing I have ever seen written about annuities. For a potential buyer, the idea is not to find a "fair value" whatever that is supposed to mean, but to see if what is being offered makes sense from the principles of annuitization. It is not your issue to allow for some bloated insurance company's costs. Your issue is to compare those that you are offered, and if still interested, all other things being equal, take the highest money's worth ratio between what you are being offered, and what is available. I think in general, most informed people would pass.

There may be special situations, the most likely I can think of is to avoid a one-off wealth tax. The authorities might have a hard time assessing and collecting on an annuity contract. SPIAssometimes have uses as judgment proofing when someone is at risk from lawsuits.

Another aspect is that much of what an annuity can do, even when things go well, can be simulated by a combination other cheaper investments, and a lower standard of living. Under current conditions, the annuity buyer says , well I don't have to lower my sol. But he forgets or ignores that any meaningful inflation will lower it for him big time. When I was a young guy, I dealt with many people of the generation who were clobbered by the big inflation of the 70s, and years of steady inflation at lower levels prior to that. Most of us are children of years of falling inflation, and our fears are different. But not many generations' fears turn out to be complete, and I doubt that ours will either.

Ha

 

[audreyh1]

I should start by saying that this critique and the Money's Worth Ratio is the most useful thing I have ever seen written about annuities. For a potential buyer, the idea is not to find a "fair value" whatever that is supposed to mean, but to see if what is being offered makes sense from the principles of annuitization. It is not your issue to allow for some bloated insurance company's costs. Your issue is to compare those that you are offered, and if still interested, all other things being equal, take the highest money's worth ratio between what you are being offered, and what is available. I think in general, most informed people would pass.

There may be special situations, the most likely I can think of is to avoid a one-off wealth tax. The authorities might have a hard time assessing and collecting on an annuity contract. SPIAssometimes have uses as judgment proofing when someone is at risk from lawsuits.

Another aspect is that much of what an annuity can do, even when things go well, can be simulated by a combination other cheaper investments, and a lower standard of living. Under current conditions, the annuity buyer says , well I don't have to lower my sol. But he forgets or ignores that any meaningful inflation will lower it for him big time. When I was a young guy, I dealt with many people of the generation who were clobbered by the big inflation of the 70s, and years of steady inflation at lower levels prior to that. Most of us are children of years of falling inflation, and our fears are different. But not many generations' fears turn out to be complete, and I doubt that ours will either.

Ha

Agreed. That was an incredibly informative article and I bookmarked it. Thanks 2B for sharing it.

 

[Running_Man]

In defense of SPIA

I am going to present my defense of SPIA based on one basic fact - it is the one investment one can make with the most predictable of cash flows over the entire retirement period and you can decide if the withdrawl rate you can earn from an SPIA investment is acceptable or not. The main questions to be answered are:

1) What is the likelihood of default?
2) How much of my annuity can I spend?
3) How do I invest any amounts not spent?

For example purposes I would use the example given of a 65 year old male offered 6.2% per annum of the investment amount. For question 1, you must do your research and find a high quality annuity provider. That risk at whatever percent is there and would be an extreme negative so no one annuity plan should be the basis of a retirement, only a portion of a retirement.

I would propose a remarkably simple, easy to implement plan, that allows for extreme clarity in future cash flows and allowable spending for an annuity portion of a retirement plan - spend one half and invest any remaining funds at the start of each year in a US Treasury 10 year bond, adjust the spending each year by the CPI reducing future investments by the amount increased.

Assume a $250,000 portfolio to invest which results in an annual payout of $15,625 and an equivalent withdrawl rate of 3.1% of the $250,000. For a totally fixed investment the withdrawl rates to be successful cannot be 4%, this is a price you must be willing to pay to beat inflation. If this is not an acceptable withdrawl rate then I think another investment vehicle would be needed.

As an example of how this investment would perform in an era of increasing inflation, the death knoll of fixed asset investment I took a look of what wouldhappen if one retired on January 1, 1964 and died on December 31,1997. The years prior to retirement had been an extremely calm time with almost no inflation but times were about to change with inflation rising above 10 percent and in the 70's and extending in to the early 1980's.

So our retiree went off contentedly spending the $7,812.50 the first year and each year took the annual CPI printed in his daily newspaper to determine how much to spend in the coming year.

In the 15th year - 1979 with our retiree at age 80 inflation had brought the spending to more than the original annuity paid. By that time our retiree would have $137,000 invested in 10 year bonds providing $8,996 of income. By age 90 the original spend of $7,812.50 would have been inflated to a need of $30,196.87. But at that age he now owned $186,000 worth of bonds providing $17,310 of investment income or more than the original SPIA provided. This is also the peak of the investment and over the following 8 years by the death of our retiree the estate would have had $133,000 worth of 10 year bonds to distribute to his heirs having spent $40,057 in his final year. Our retiree lived his entire 33 year retirement in economic oblivion with fixed instruments and never a cutback in spending or an issue of cash flow, nor a decision on to whether to buy or sell something or if he should take precautionary cutbacks.

Over his retirement our retiree spent a total of $717,355 dollars with $531,250 having been provided by the SPIA. Interest earned in the retirement years was $318,884.

The most important point in my view is that at any point in time after the first 10 years of investing the retiree could plan minimum cash available to spend for the coming 10 years in precise terms. With the cash from annuity, dividend payments and principal payments all on a fixed schedule. I think predictable cash flows make quite a good component of a retirement plan and the value of predictable cash flow is not seen well enough by a population more concerned about optimization of investment returns.

 

[Kimo]

These statements are so hard to read/follow when you consider the differences between annuities that are sold through individuals vs. ones you buy through a brokerage company that doesn't involve an insurance company. There really needs to be two different threads.

You can sell your brokerage annuity back to the brokerage 5 days or 5 years or 20 years, etc.after you buy it with no penalties at all. None.

Another overlooked item is when considering the HCA these annuities are not counted towards income because they are mutual fund holdings.

Also, the dividends are not listed out as an individual line item so there is no tax on them either. The value of your mutual fund just rises.

Your yearly income rises (assuming the stock market rises) but can never fall if the market falls.

I own 3 of these and they are the best INVESTMENT purchase I have made. That's right, they are an investment. It is the Wellington mutual fund that I hold right next to the same Wellington mutual fund in my same brokerage account.

I can't remember the exact difference in fees but I think it was 0.24% or less.

 

[REWahoo]

I've learned that buying an annuity is a lot like buying a car - if you think you got a good deal, that's all that really matters.

 

[NW-Bound]

From 1/1968 to 1/1983, cumulative inflation rate was 187%. This means that in a mere 15 years, a dollar became 1/(2.87) = 35 cents. Not all of those years saw inflation in the double digit range. The highest was 13.5% in 1980, but only 3.2% in 1972, and 4.2% in 1968. It's the compounding effect that made it so bad.

Both stock and bond returns barely match inflation in the above period, but it was still better than holding cash, and annuities too I would think.

 

[2B]

I am going to present my defense of SPIA based on one basic fact - it is the one investment one can make with the most predictable of cash flows over the entire retirement period and you can decide if the withdrawl rate you can earn from an SPIA investment is acceptable or not.

I said in my post that some people feel comfortable with them. That is a personal issue.

You had a long example during the worst increase in inflation our country has faced since the late-1800s. I wonder what the answer would be if a ladder of 10 yr treasury bonds were used instead of a one time purchase of the annuity. After all, the $250,000 had to come from somewhere. I also have no clue whether the annuity rate you used was correct (up or down) at the beginning of your term. My recollection of interest rates in the late 60's has the 10 yr treasury above 6%. Mortgages were definitely above 6%.

 

[NW-Bound]

The annualized inflation in the 15-yr period that I cited above is 7.3%, for a reference.

 

[Running_Man]

I said in my post that some people feel comfortable with them. That is a personal issue.

You had a long example during the worst increase in inflation our country has faced since the late-1800s. I wonder what the answer would be if a ladder of 10 yr treasury bonds were used instead of a one time purchase of the annuity. After all, the $250,000 had to come from somewhere. I also have no clue whether the annuity rate you used was correct (up or down) at the beginning of your term. My recollection of interest rates in the late 60's has the 10 yr treasury above 6%. Mortgages were definitely above 6%.

The 10 year treasury on January 1st 1964 was 4.17% A 10 year ladder at the time would have been earning 3.67%, slightly higher than a 10 year ladder of 10 year bonds would have produced at the start of 2013. I am quite certain that a 3.1% withdrawl rate is not sustainable with an initial 3.67 payout from fixed income

 

[Running_Man]

From 1/1968 to 1/1983, cumulative inflation rate was 187%. This means that in a mere 15 years, a dollar became 1/(2.87) = 35 cents. Not all of those years saw inflation in the double digit range. The highest was 13.5% in 1980, but only 3.2% in 1972, and 4.2% in 1968. It's the compounding effect that made it so bad.

Both stock and bond returns barely match inflation in the above period, but it was still better than holding cash, and annuities too I would think.

If I adjust my plan to starting on 1/1/1968 by 1/1/1983 spending needs go from 7,812.50 to $22,567.13. It took only 12 years to be spending more than the annuity paid out. However, the retiree would still not have been forced to decrease spending adjusted for inflation up to age 95.

It is likely that an annuity quote on 1/1/1968 would have been higher for a 65 year old man than 6.2% but for illustration purposes this simple plan would still have worked if it started out during the worst inflation era of the US