4% Graded Payment in Annuity as Fixed Income Portion

[Running_Man]

Having looked at the payouts for annuities on the Vanguard Website, I am at a loss to understand how the choice of an annuity with a 4% graded option is not underpriced. For a 55 year old man Vanguard (AIG I realize) would pay an initial amount of 4% annually and step up 4 percent per year with a 28 year guaranteed payout period. My assumption is that inflation should average 3-3.5% per year over the next 45 years. Firecalc shows only a 94% success rate for 4% withdrawls with a 75% stock component for just 30 years.

After just 9 years using the last nine years CPI as a benchmark the annuity would be paying 12% better than inflation as reported by the government. I really do not care what fees Vanguard or AIG think they will be making, I am looking at the potential payout for security vs alternatives and questioning that AIG is underpricing this financial instrument.

True enough in times of high inflation this would not be a great move however that would be the problem of all fixed instruments and this would be superior to most alternatives. In times of modest deflation the standard escalator would be a huge benefit. The excess of most years to the inflation rate is a reward that I would think would well be worth taking and makes me wonder how is this not superior to bonds as the fixed component of one's retirement portfolio?

 

[haha]

The excess of most years to the inflation rate is a reward that I would think would well be worth taking and makes me wonder how is this not superior to bonds as the fixed component of one's retirement portfolio?

Given your assumptions it likely would be superior. But it is less flexible, less amenable to mid-course corrections.

Ha

 

[Independent]

After just 9 years using the last nine years CPI as a benchmark the annuity would be paying 12% better than inflation as reported by the government. I really do not care what fees Vanguard or AIG think they will be making, I am looking at the potential payout for security vs alternatives and questioning that AIG is underpricing this financial instrument.

I can't comment on whether this would be a good or bad investment for you, but I can say something about whether AIG is underpricing.

If I'm reading you correctly, you are a 55 year old male. They are selling a single life annuity with an initial payment of 4% of your premium (let's say you pay $100,000 and they pay you $4,000 in the first year). After that, their payments increase 4% per year. They will pay for your life or 28 years, whichever is longer.

I think they need to invest your premium at 6.09% just to cover your checks, and they need something more than that to cover expenses and make a profit.

You may have already done the math, but this is the way I worked it out-- Suppose they can invest the $100,000 in bonds that which have semi-annual coupons of 3%, and have a laddered maturity to exactly match the cash needs. I'll assume they pay you in the middle of each year to keep the math simple.

In the first year, the $100,000 grows to $103,000 by the middle of the year. They pay your $4,000 (presumably $3,000 from coupons and $1,000 from maturities). The remaining $99,000 grows to $105,029 by the middle of the second year. They pay you $4,160, leaving $100,869, which grows to $107,012 by the middle of the third year when they pay you the next $4,326, etc.

At the end of the 28th year, they have $82,698 left. If you are alive, your next payment will be $11,995. You will be 83. According to the Vanguard quote page, they need approximately $116,000 to fund a life annuity at age 83 with a first payment of $11,995 and 4% annual increases.

But that's only if you are alive. If you're dead, they don't need anything. If they figure that about 70% of the 55 year-old males survive to 83, then they've just about broken even (since 70% of $116,000 is just a little under $82,69).

Of course, they have expenses and profit. So they need to be able to buy this laddered mix of bonds that pays something above 6.09% if they plan to cover their costs and make a profit. [Assuming in all of this that I haven't messed up the math somewhere, or grossly misjudged the 70%.]

Now the question of underpricing comes down to how much they can really make on your money. AIG may actually go into the bond market with this money. If they can really get something over the 6.09% on a diversified mix of quality bonds, then they can make it. But Treasuries vary between 4.12 and 4.84 today. It seems that they need to get at least 200 basis points over treasuries to make a profit. Mortgages are around 6.00 (to the borrower). So they need to earn more than retail mortgage rates. That seems pretty challenging to me.

AIG's a big company, probably has lots of sophisticated investment strategies, may be using cash generated on one side of the company to fund a business on the other. But all these fancy things need to be structured so they still look solvent to insurance regulators.

I'll leave it to the better investors on this forum to estimate how much risk AIG has to take to get to get yields comfortably over 6% today.

 

[heyyou]

Spendthrift government prints inflated dollars to cover its debts. AIG is betting on inflation to cover its commitments.

 

[2B]

Independent did a nice investment discussion.

AIG is a big company with lots of smart people that use very sharp pencils. I am very sure they are not expecting to lose money. Part of the game is people die so they can stop paying. Part of the game is investing in the same type of things we can and some things we can't but not many. Comparing it to FIRECalc is not a fair comparison because most cases with FIRECalc there is a significant remainder. The annuity goes to zero upon death.

You can be sure you're not "taking advantage" of the AIG. They pay lots of people big salaries and build fancy buildings with the profits they make off of us. Also, remember that AIG (or a subsidiary) backs the annuity so you're putting all your eggs in the AIG basket. Insurance companies have been known to fail.