Annuities as an Investment

[Independent]

I'd like to pursue this a little more.

I agree that the biggest question is will the insurance company pay off. History has never shown a loss. That doesn't mean it can't happen but it's safer than a few things out there.

I don't understand the "what do people get on average" comment. If there has never been a default in history, it seems to me they get exactly what they deserve based on how long they actually live. If I die early, I understand I lost out, but at least I am dead. If I live to 100, I robbed the bank.

I thought I could put a response in a couple paragraphs. I was wrong. Sorry for the length. I probably mis-read you questions somewhere.

When I said "what people get on average" I meant the "expected value" as defined by Wiki:

In probability theory the expected value of a discrete random variable is the sum of the probability of each possible outcome of the experiment multiplied by the outcome value (or payoff). Thus, it represents the average amount one "expects" as the outcome of the random trial when identical odds are repeated many times. Note that the value itself may not be expected in the general sense - the "expected value" itself may be unlikely or even impossible.

Note that this is exactly what Ha suggested, and the calculation method I outlined.

Here's an example. You and I agree to buy a $3,000 CD. I put in $1,000 and you put in $2,000. We let the CD interest accrue inside the CD. Say it grows to $4,000. At maturity we flip a fair coin, the winner gets the entire proceeds. The expected value of the payoff is the same for both of us - $2,000. But notice that neither one of us can actually recieve $2,000. One of use will get $0 and the other will get $4,000.

If I ask the question "What is the game worth to me?", I'll discount the final payoff to today so I can fairly compare it to my cost. The present value of the expected value of the payoff is again the same for both of us, and is $1,500 if we discount at the CD interest rate. So the game is worth $500 to me, and -$500 to you. If we played it many times, that would be our average gains and losses, even though no single round can give either of us $500.

In words that you've used, if I wanted to get the expected value of this game ($2,000 at maturity) on my own, I would need to buy a CD for $1,500 - which is $500 more than I'm putting into the game. So the game looks like a good deal to me. Similarly, it's a bad deal for you.

I don't think 86 is an unusually old age, maybe you do. Since I don't think 86 is unusual, I look at the 6% IRR. What age do you base your calculations on when you do financial planning? I think that has merit.

Again, it depends on the question. In the CD example above, the maximum payoff is $4,000 at maturity. That's an important number if you're trying to decide whether to play the game, but it's not the only number you should look at.

In an insurance policy, a couple important questions are "What's the most I could get out if this, if the really bad thing happens? And, how much will I get out of this if a kind of bad happens?" I think that's what you're doing with your live-to-86 example, calculating how the thing looks if a "kind of bad thing" (strictly in the financial sense) happens. I think that's a good question to ask and answer. But it's not the whole picture on a close decision.

I sure don't understand your "Less than they put in" (adjusted for the time value of money) comment. They pay over out time (if the insurer stays solvent) as much as CD's and bonds do. Does the "less than they put in" apply to CD's and bonds also?

On the last comment, why is a 4.5% to 7% IRR at all tied to the comment "how much do they lose on average"? Are you comparing an annuity to a 50/50 portfolio or something? I don't understand that.

Regarding bonds, let's suppose that you have a history of investing in Treasuries. But today, you're looking at a "B" rated bond. The Treasury has a 100% chance of paying each coupon and the principal on time. The B bond doesn't. It's coupon rate is higher, so if it pays off it's better than the Treasury. You can do the calculation and it might show that $900 invested in the B bond, if it pays in full, will provide as much cash as $1,000 invested in the Treasury. That's a good place to start your analysis. You now know your maximum upside. But, you also want to know the downside. Well, the issuer could go belly-up tomorrow, so the worst case is -$900. But, that's very unlikely.

Your gut tells you that there is some number between -$900 and +$100 which is some sort of average. To do that calculation, lay out a string of probabilities for the B bond paying each of it's coupons, and the maturity payment. (The probabilities are typically a decreasing string of numbers, since the issuer is probably in okay shape today, but your concern is that it will deteriorate over time.) You multiply the probabilities by the corresponding cash flows, discount to today at the Treasury rate, and that gives you a number that is somewhere between the best and worst case. If that number is less than the purchase price of the bond, then I would say you should expect to "get less than you put in (adjusted for the time value of money, which is the Treasury rate)"

In the annuity case, you do the same calculation, but the probabilities are based on a mortality table instead of the possibility of the insurer going under (because you've specified that risk is small enough to ignore). The discount rate may not be Treasuries, because you feel that you're a good enough investor to get something a little better than that. Assuming that you can get the same rate that the insurance company does, then you are using the same method that they use to price the annuity and you're using the same discount rate. If you happen to pick the same mortality table, then you will find that you're "expected loss" is exactly the present value of their expenses and profit.

So SamClem says that this method will always show a loss to you, unless you know something about your mortality that they don't (or they can get better investments than you can).

That doesn't mean you should never buy insurance. It just means that you should understand that when you add up all the policyowners of an insurance company, their total dollars back will be less than their premiums (adjusted for the interest they could have earned). You don't buy insurance because you expect to beat the insurer at it's own game. You buy because you're trying to reduce the uncertainty in your financial life, which has a value that is measured in "utility" not "dollars".

 

[Rich_by_the_Bay]

Good point, Independent. And in this case we shouldn't discount the utility of decreased nest egg volatility for some investors, loss of large sums for the heirs, if any, and increased portfolio survival (decreased failure rate, not final net worth) according to recent studies I'm too lazy to dig up.

Depending on the importance of those factors and I'm sure many others, the annuity decision may swing one way or the other quite drastically. That's the non-money part.

I've gone from keen interest in SPIAs a couple of years ago (based on misunderstanding and naivete) , to total rejection of the idea, to where I am now -- I will consider it as a unique diversifier in my portfolio around age 65 under pretty specific circumstances and amounts. It's not a slam dunk.

 

[RockOn]

I thought I could put a response in a couple paragraphs. I was wrong. Sorry for the length. I probably mis-read you questions somewhere.

When I said "what people get on average" I meant the "expected value" as defined by Wiki:

Note that this is exactly what Ha suggested, and the calculation method I outlined.

Here's an example. You and I agree to buy a $3,000 CD. I put in $1,000 and you put in $2,000. We let the CD interest accrue inside the CD. Say it grows to $4,000. At maturity we flip a fair coin, the winner gets the entire proceeds. The expected value of the payoff is the same for both of us - $2,000. But notice that neither one of us can actually recieve $2,000. One of use will get $0 and the other will get $4,000.

If I ask the question "What is the game worth to me?", I'll discount the final payoff to today so I can fairly compare it to my cost. The present value of the expected value of the payoff is again the same for both of us, and is $1,500 if we discount at the CD interest rate. So the game is worth $500 to me, and -$500 to you. If we played it many times, that would be our average gains and losses, even though no single round can give either of us $500.

In words that you've used, if I wanted to get the expected value of this game ($2,000 at maturity) on my own, I would need to buy a CD for $1,500 - which is $500 more than I'm putting into the game. So the game looks like a good deal to me. Similarly, it's a bad deal for you.



Again, it depends on the question. In the CD example above, the maximum payoff is $4,000 at maturity. That's an important number if you're trying to decide whether to play the game, but it's not the only number you should look at.

In an insurance policy, a couple important questions are "What's the most I could get out if this, if the really bad thing happens? And, how much will I get out of this if a kind of bad happens?" I think that's what you're doing with your live-to-86 example, calculating how the thing looks if a "kind of bad thing" (strictly in the financial sense) happens. I think that's a good question to ask and answer. But it's not the whole picture on a close decision.



Regarding bonds, let's suppose that you have a history of investing in Treasuries. But today, you're looking at a "B" rated bond. The Treasury has a 100% chance of paying each coupon and the principal on time. The B bond doesn't. It's coupon rate is higher, so if it pays off it's better than the Treasury. You can do the calculation and it might show that $900 invested in the B bond, if it pays in full, will provide as much cash as $1,000 invested in the Treasury. That's a good place to start your analysis. You now know your maximum upside. But, you also want to know the downside. Well, the issuer could go belly-up tomorrow, so the worst case is -$900. But, that's very unlikely.

Your gut tells you that there is some number between -$900 and +$100 which is some sort of average. To do that calculation, lay out a string of probabilities for the B bond paying each of it's coupons, and the maturity payment. (The probabilities are typically a decreasing string of numbers, since the issuer is probably in okay shape today, but your concern is that it will deteriorate over time.) You multiply the probabilities by the corresponding cash flows, discount to today at the Treasury rate, and that gives you a number that is somewhere between the best and worst case. If that number is less than the purchase price of the bond, then I would say you should expect to "get less than you put in (adjusted for the time value of money, which is the Treasury rate)"

In the annuity case, you do the same calculation, but the probabilities are based on a mortality table instead of the possibility of the insurer going under (because you've specified that risk is small enough to ignore). The discount rate may not be Treasuries, because you feel that you're a good enough investor to get something a little better than that. Assuming that you can get the same rate that the insurance company does, then you are using the same method that they use to price the annuity and you're using the same discount rate. If you happen to pick the same mortality table, then you will find that you're "expected loss" is exactly the present value of their expenses and profit.

So SamClem says that this method will always show a loss to you, unless you know something about your mortality that they don't (or they can get better investments than you can).

That doesn't mean you should never buy insurance. It just means that you should understand that when you add up all the policyowners of an insurance company, their total dollars back will be less than their premiums (adjusted for the interest they could have earned). You don't buy insurance because you expect to beat the insurer at it's own game. You buy because you're trying to reduce the uncertainty in your financial life, which has a value that is measured in "utility" not "dollars".

I'll have to digest that for awhile. I'll get back to you on a few points, I don't have time tonight.

One thing that immediately comes to my mind is that you seem to be saying that I lost out if the isurance company actually get a better deal than I do. In my mind if the insurance company makes 10% and pays me 6% that is still perfectly fine with me. I know I probably could have invested in a portfolio and could have made the same 10% myself, but it is fair to me because they took the volatility out of my returns and the also assumed the risk of my portfolio not earning 6% which is my meaningful threshold. Am I reading that correctly?

Another thing is that you seem to be saying I am playing the mortality table odds. I don't really see this as a risk game (except for risk the insurer defaults). The payouts are determined upfront, there are no surprises. We all know anything can happen and life involves risk. My decision would be based upon the idea that if I die really early, I lost and so did my heirs so I would never put all my money in an annuity unless it was hedged with life insurance. However, if I am willing to accept a 5% IRR for myself and my heirs if I die at 78; or a 6% IRR if I die at 86; or a 7% IRR if I die at 92; what risk am I taking? I knew the outcome upfront and it was acceptable to me.

 

[RockOn]

Good point, Independent. And in this case we shouldn't discount the utility of decreased nest egg volatility for some investors, loss of large sums for the heirs, if any, and increased portfolio survival (decreased failure rate, not final net worth) according to recent studies I'm too lazy to dig up.

Depending on the importance of those factors and I'm sure many others, the annuity decision may swing one way or the other quite drastically. That's the non-money part.

I've gone from keen interest in SPIAs a couple of years ago (based on misunderstanding and naivete) , to total rejection of the idea, to where I am now -- I will consider it as a unique diversifier in my portfolio around age 65 under pretty specific circumstances and amounts. It's not a slam dunk.

Those are great points

 

[FIREd]

I have definitely not rejected the idea of buying a few SPIAs later on to build kind of a pension (hopefully they could generate enough income to cover all basic expenses). But I consider them income insurance products and not "investments". Once you buy the annuity, the money is not yours anymore. And when you die, your "investment's" value goes instantaneously to zero (unlike real investments like RE, stocks, bonds and cash). In fact your "investment's" return depends in large part on how long you live after buying the annuity. If you die soon after buying the annuity, you will have lost a bunch of money. Live until 120 and you will bring the executives at your insurance company to tears. And since none of us know for sure when our time will come, it is futile in my opinion to look at annuities as investments.

 

[RockOn]

I have definitely not rejected the idea of buying a few SPIAs later on to build kind of a pension (hopefully they could generate enough income to cover all basic expenses). But I consider them income insurance products and not "investments". Once you buy the annuity, the money is not yours anymore. And when you die, your "investment's" value goes instantaneously to zero (unlike real investments like RE, stocks, bonds and cash). In fact your "investment's" performance depends in large part on how long you live after buying the annuity. If you die soon after buying the annuity, you will have lost a bunch of money. Live until 120 and you will bring the executives at your insurance company to tears. And since none of us know for sure when our time will come, it is futile in my opinion to look at annuities as investments.

Good points but I still do not see why that is futile to look at annuities as investments. As an example, I assume that many are trying to get to a inflation adjusted SWR of 4% to retire (or something like that). Wherever one puts there money to get there is an investment in my mind. Putting some money in annuities can make the 4% SWR a reality with less risk, at least I think that has been claimed by several experts by now. Even though it's an insurance product, I still see it as an investment but the semantics of that are really not important. It's not my goal to have you see it as an investment.

 

[FIREd]

Wherever one puts there money to get there is an investment in my mind. Putting some money in annuities can make the 4% SWR a reality with less risk, at least I think that has been claimed by several experts by now.

So when you contribute money to SS and/or a pension, do you consider them "investments"? Because they do meet the criteria you described above. I am not trying to pick a fight, just trying to understand your POV.

 

[rs0460a]

Another point...

Just an additional two points (since I actually have an SPIA and I went through a lot of the same decision process you are talking about, two years ago).

1. The SPIA was purchased with (what was at the time) 10% of my/DW's retirement portfolio value. That means that 90% remains to try to "fight inflation", and to face the reality that the rate of return would be lower due to our "young age" (59) at the time of purchase.

2. Our remainder estate is going to charity. That's a big point (IMHO) in our decision making process.

Right now, the SPIA provides about 33% of my income (my wife is still employed, so it would be less if we included her required income). At this time it is a 10% "bet" to provide 33% income. Not a bad ratio, at this time.

The rate is not as good as we could have gotten with another SPIA vehicle, since it does include payments for a "guaranteed minimum period" (which will actually pay out at least 2x our original "investment"). It includes payments on both our lifetime's (with remaining payments to our estate if we both pass before the 28 year period ends).

After a year of getting payments, I'm pleased with the results, and will consider further "investments" in the future. As for you? Well, that's your decision.

- Ron

 

[Kronk]

I'm certainly going to consider annuities as I get older. Maybe even staggering them across different providers and purchased at different times. Whatever. Currently, at age 34, a inflation-adjusted SPIA with DW and 75% survivor benefit would get me an initial withdrawal of 3.3%. Definitely not worth it, but then it isn't supposed to be at my age.

The biggest problem with building your retirement stash is the variability of returns. 4% will succeed almost all the time, but you end up with a huge variation in portfolio value after 30 years depending on the market. If I don't care much (at all?) about how much money I leave potential heirs, then I'm most likely better off at a 5% annuity than a 4% withdrawal. Exchanging potential returns for a higher guaranteed* return that allows me to live my life the way I'd like to doesn't seem like a horrible tradeoff. I'll personally be keeping an eye on SPIA's in the coming decades, though that might tie into the future of Social Security as well...

*Of course, tying up all my money wouldn't be a good idea either, risk of the insurance provider going belly up, yadda, yadda.

 

[donheff]

Rock -- quit trying to justify SPIAs as an investment. People have clearly demonstrated it is not a good investment relative to other simple approaches. It is longevity insurance and a source of guaranteed income. You have said you want to "lock in" your retirement plan. OK - that doesn't sound like you are evaluating investments - you are looking for guarantees. Look at the SPIAs from that perspective. Are you single or married? How much income do you need? What will the SPIA give you versus what are you comfortable pulling from your nest egg? For example, you can get a Vanguard inflation protected annuity with 100% spousal coverage for a pair of 60 Y/O today paying out 4.55% the first year. If you simply want more spending now vs. a nest egg to pass on in the future, is 4.55% a better initial SWR than you would be willing to pull on your own? If so, buy the SPIA. A single 60 Y/O male buying the same annuity could start with a 5.487% SWR. Again, if all he wanted was a higher spending rate now that probably compares favorably to what he would risk pulling from his portfolio. Check your state guarantees to see how large an annuity they cover -- also verify whether the state would guarantee several individual annuities, or one for you and one for your spouse. That may help you think through how much you could put into an SPIA and be "guaranteed."

 

[REWahoo]

Rock, it appears you are playing a game with members of this forum entitled "How long can I keep the annuity discussion going and how many people's buttons can I push while doing so." It is nothing more than a form of trolling.

I don't make this accusation lightly. If you care to examine my posting history you will find few if any other complaints of trolling, but your pervasive harping on this subject with repeated, "just one more thing and I'm through" claims is clearly a ruse.

I'm hoping other members will see your tactics and stop feeding the troll. Better yet the mods will agree with my lament and give you a vacation from the forum.

 

[2B]

It is nothing more than a form of trolling.

I always knew you were a bigot. What do you have against the trolls?

I totally agree with you. RockOn has become a pain-in-the-forum. He has gone beyond the reasonable amount of questioning for even the dullest of posters. If he isn't a troll, he's probably not going to get any benefit from those that will reply to him.

Almost all of his posts have been SPIA related and all repeating the same beaten to death themes.

 

[Dawg52]

Almost all of his posts have been SPIA related and all repeating the same beaten to death themes.

That's true. Basically that is what most topics become on a forum board. Just re-styled asking the same old same old. Let's just shut the whole board down in fear of the troll!

 

[HFWR]

While sometimes annoying, I have no particular objection to one-trick [-]trolls[/-] ponies. I just wonder why, if they don't want to talk about anything but X, that they hang around on an er board. There are financial boards and political boards galore, if those are your only interests...

 

[2B]

That's true. Basically that is what most topics become on a forum board. Just re-styled asking the same old same old. Let's just shut the whole board down in fear of the troll!

I agree and disagree at the same time.

It's true we "plow the same field" with many posts but they are usually started by a newbie. On the subject of annuities you can expect me to make my normal post listing their deficiencies. Others will defend them with their same arguments.

There are a lot of new topics that come up. Some are more novel and interesting than others.

When someone clearly is guilty of "trolling," a swift and sure limit on their access to the forum is reasonable.

 

[rs0460a]

On the subject of annuities you can expect me to make my normal post listing their deficiencies. Others will defend them with their same arguments.

Talking about me, again?

- Ron

 

[haha]

If trolls seem to have a sense of humor, which I would say that Rock does, what's not to like?

If nothing else it is a somewhat off to the side behavior that can be diverting. Not to mention the joke set-ups that trolls provide.

Ha

 

[REWahoo]

That's true. Basically that is what most topics become on a forum board. Just re-styled asking the same old same old.

True. But when the same poster asks the same old same old, on and on and on, I catch a whiff of disingenuousness.

 

[HFWR]

True. But when the same poster asks the same old same old, on and on and on, I catch a whiff of disingenuousness.

A whiff of something...

 

[unclemick]

A whiff of something...

Psssst - Wellesley?



Just could not resist.

heh heh heh - "Never apologize Mr Cahill, it's a sign of weakness."

John Wayne for those who don't remember

 

[RockOn]

So when you contribute money to SS and/or a pension, do you consider them "investments"? Because they do meet the criteria you described above. I am not trying to pick a fight, just trying to understand your POV.

Yes I do, however in those cases they might be thought of as non-discretionary investments. They all add to reaching a goal, a funded retirement in my case.

 

[RockOn]

Rock -- quit trying to justify SPIAs as an investment. People have clearly demonstrated it is not a good investment relative to other simple approaches. It is longevity insurance and a source of guaranteed income. You have said you want to "lock in" your retirement plan. OK - that doesn't sound like you are evaluating investments - you are looking for guarantees. Look at the SPIAs from that perspective. Are you single or married? How much income do you need? What will the SPIA give you versus what are you comfortable pulling from your nest egg? For example, you can get a Vanguard inflation protected annuity with 100% spousal coverage for a pair of 60 Y/O today paying out 4.55% the first year. If you simply want more spending now vs. a nest egg to pass on in the future, is 4.55% a better initial SWR than you would be willing to pull on your own? If so, buy the SPIA. A single 60 Y/O male buying the same annuity could start with a 5.487% SWR. Again, if all he wanted was a higher spending rate now that probably compares favorably to what he would risk pulling from his portfolio. Check your state guarantees to see how large an annuity they cover -- also verify whether the state would guarantee several individual annuities, or one for you and one for your spouse. That may help you think through how much you could put into an SPIA and be "guaranteed."

Thanks for the response. An annuity actually pays out both principle and a payment based on the IRR. Because of that I don't see how I have lost my nest egg, I can reinvest my principle if I so choose. Looking at it that way the nest egg is not gone. The question is whether the payment based on the IRR is sufficient to be reasonable. I think 5, 6, or 7% might meet that test for some of us.

On the state guarantee, I would be looking into and considering that.

 

[RockOn]

Rock, it appears you are playing a game with members of this forum entitled "How long can I keep the annuity discussion going and how many people's buttons can I push while doing so." It is nothing more than a form of trolling.

I don't make this accusation lightly. If you care to examine my posting history you will find few if any other complaints of trolling, but your pervasive harping on this subject with repeated, "just one more thing and I'm through" claims is clearly a ruse.

I'm hoping other members will see your tactics and stop feeding the troll. Better yet the mods will agree with my lament and give you a vacation from the forum.

I was asked to take this to a seperate annuity thread so others don't have to put up with another annuity discussion if they so choose. I did. I will no longer even mention annuities in any other thread. I might defend someone who is ridiculed for bringing them up though as that is unfair. I am just exploring the possibilities they provide. Sorry if it seems trollish to you but I think there are still some valid points and some good information being posted. By that, I don't mean by me. This thread will end when it ends, don't let it worry you.

 

[REWahoo]

...I think there are still some valid points and some good information being posted. By that, I don't mean by me.

It's nice that we can find common ground on at least one point.

 

[RockOn]

True. But when the same poster asks the same old same old, on and on and on, I catch a whiff of disingenuousness.

My only comment to the series of troll comments is....sorry for that. I really only want to talk about the viability of a SPIA but I'm glad I do provide entertainment for some of you.

Now let me think about what Independent said again. He always floors me with his thorough and calculated thinking.