Do annuities fit into an ER plan? (SWR-related)

[mathjak107]

lets see ,an annuity...what a great idea for a money maker...you give us say 100,000 up front ..we then give you back your own money for 14 years...hmmmmm total return on investment zero...next ill give you 8,000 of the interest we earned over the last 14 years with your money...lets see 8,000 on 100,000 over 15 years is less then 1% return....year 16 i get another 8,000 so now we got 16,000 in 17 years on our 100,000.......boy these annuity companies got a great one here.....

 

[Gearhead Jim]

Yeah, kinda like a home insurance policy...

you give us several hundreds or thousands of dollars per year and we give you...   nothing, if you're lucky.  But if you're unlucky (house burns down), then the insurance is the best bargain of your life. 

An annuity is similar in that you are "insuring" against the possibility of living "too" long, bad investment decisions, bad market conditions during your retirement, ulcers from worrying about your investments, etc.

Annuities have some significant downsides, as has been posted above (by me, too).  In my own case, having a modest fixed pension plus SS is enough "annuity" that I likely won't buy any more.

Your reply does not address the fact the the FIRE calculator shows a slight advantage, at least for some people, to having an immediate INFLATION-indexed annuity. When I run the same program with an immediate FIXED annuity, the results always come out worse.

"The vehemence of some anti-annuity posts here makes me just as suspicious as the enthusiasm of some annuity salesmen."  Still true.

 

[cute fuzzy bunny]

Can you share the way you induced firecalc to provide an advantage for the immediate inflation indexed annuity? I've tried every way from sunday to find an annuity approach that beats plain old investing over the long haul. Unless I figure i'm going to live well into my 90's (a statistical unlikelihood even with several people in my family having done so), I cant get it to turn that way.

As far as the anti-annuity, the moment someone shows me one that makes sense for more than a small portion of my investments (as another 'slice' in the 'dice as it were), I'll say some very positive things. As it stands, the primary advantages are it assures payment as long as you live and gives an emotional safety net. Note i'm not knocking those things, I just try to make sure I know that i'm buying emotional benefits with money. Sometimes thats a good trade. Right now every apples to apples comparison i've made on an annuity vs an equal standard investment shows me a 20-30% benefit financially to steer away from the annuity. Thats a stiff cost.

Face it, if these things werent a big money maker for the insurers that offer them, they wouldnt offer them. Someones paying for those profits. I dont think i'll be one of them.

The analogy to home insurance isnt entirely an apple to apple to me. If my home burns down or gets hit by a car, its an immediate and unrecoverable loss. I cant wait a while and watch the damage go away. There are few things that would result in permanent loss of funds from a well diversified investors stash. Those things (complete economic meltdown in the US, nuclear war, widespread pandemic, etc) would have such a fundamental effect on so many things that A) I dont think i'd be feeling too good about some insurance company making my payments for another 20 years and B) Even with a badly damaged or nearly wiped out portfolio, I'd still have a huge economic advantage over the masses of great unwashed regular working people.

Once again, you dont have to outrun the bear, just the other guy it can eat instead.

 

[Gearhead Jim]

I'm away from the data I used for the FIREcalc entry but i should be able to repost tomorrow. And I'm still puzzled why putting a small portion of my portfolio into an inflation-indexed annuity seems to help my portfolio survival, but putting in a larger portion does not. As mentioned, I could not find any combination for me where a fixed annuity helped, only the inflation-adjusted one could be useful.

I don't have an emotional stake in this argument, just trying to figure out what might work best for both myself and for others.

 

[brewer12345]

Face it, if these things werent a big money maker for the insurers that offer them, they wouldnt offer them.  Someones paying for those profits.  I dont think i'll be one of them.

Hmmm, actually I think I can come up with a scenario under which an insurer would be happy to offer a payout annuity for a small profit. Imagine a big life insurance company with a lot of old fashioned life insurance policies on the books. When do they get hurt the worst? When lots of people croak before the actuaries have forecast them to do so. Not so pretty, right?

What if that insurer could sell a product which offered greater profits when people croaked early? Might the insurer be willing to sell that product at a lower rate of return (to the insurer) in order to hedge some of their existing risk? Sure. So a company with lots of life insurance policies might be willing to sell a payout annuity with rich benefits.

Not saying this is the way it works (it isn't), but sometimes things aren't quite as cut and dry as they might seem.

 

[laurence]

Hmm, interesting thought, brewer. But the company would have to control the buying pool, right? If they sold these small profit annuities to different people then held their life insurance policies, they could get a perfect storm of short lived life insurance holders and long lived annuity holders. I'm thinking a mailing that says, "A special offer to our current valued customers....".

 

[brewer12345]

Hmm, interesting thought, brewer.  But the company would have to control the buying pool, right?  If they sold these small profit annuities to different people then held their life insurance policies, they could get a perfect storm of short lived life insurance holders and long lived annuity holders.  I'm thinking a mailing that says, "A special offer to our current valued customers....".

Maybe, or maybe you just make sure that your pricing and underwriting are geared to attract certain populations to your products. You could also market through targetted channels to avoid getting stuck with the wrong demographic. Insurers have 100+ years of avoiding "adverse selection", although some choose to ignore all those years of painful experience in favor of pumping up the next quarter's results.

 

[laurence]

You know, the profits are so fat, you'd think there would be room for someone to enter the market, slightly undercut the competition and run away with phat market share....brewer, maybe we should PM about this.

Know any venture capitalists?

 

[wstu32]

I just dont trust any insurance companies.
I had a friend who worked for a major insurance co.
I can not verify or deny this story...
but he said the insurance co. have teams of attorney's to
"fight" any and most claims!

~if true, gotta make you sick!

 

[brewer12345]

You know, the profits are so fat, you'd think there would be room for someone to enter the market, slightly undercut the competition and run away with phat market share....brewer, maybe we should PM about this. 

Know any venture capitalists?

The problem with this great idea is that there are already lots of players in the industry who are pricing annuities aggressively. To give you an idea, there is some arbitrage currently going on for healthy seniors who have some money moldering away in a CD:

- Step 1: cash in the CD
- Step 2: buy an immediate annuity (not inflation indexed)
- Step 3: buy a life insurance policy that pays out the amount of the CD principal on death and has guaranteed no-lapse premiums for life of less than the ammount the annuity pays every year

For the right individuals, you can set this up so the amount paid out by the annuity every year in excess of the life insurance premiums is greater than the interest they can get on the CD (plus the agent walks away with a big, fat commission check). In that case, the agent and customer win and either the seller of the annuity, life policy or both have made a mistake and will be very sorry in a few years...

 

[cute fuzzy bunny]

Brewer - thats pretty much the fundamental business model for insurance companies, isnt it? Offer products that are profitable when the risk is mitigated across a wide enough pool and hedge insurance and reinsurance risk by other products that are counter to those?

Jim - I really dont have any stake in this either. I run the numbers, see what it looks like, see how it feels, then go or dont go. I think I know the answer to your question as to why a small bit helps and a large bit hurts. An income stream helps a portfolio...sometimes substantially. When you have pretty thin times, the income stream helps cut down on depleting beaten down shares. When you put too much in annuities, you're losing the historical upside return premium of equities.

Put a little honey in your chili and it improves the taste and allows you to increase the 'heat' without it increasing the apparent spiciness. Put a gallon in...not so much.

 

[brewer12345]

Brewer - thats pretty much the fundamental business model for insurance companies, isnt it?  Offer products that are profitable when the risk is mitigated across a wide enough pool and hedge insurance and reinsurance risk by other products that are counter to those?

Not exactly. What life insurers try to do is sell a product that can be stripped down to borrow cheap and lend/invest dear, with the other risks assumed from the customer either washed out in the aggregate (in large numbers, people mostly die "on time") or can be hedged for less than you charge the customer to accept the risk (the equity component in equity indexed annuities hedged with futures and options; or reinsuring risks). What is left after you hedge all that out is money that the customer has effectively given you in return for interest that is equal to or less than treasuries/LIBOR. The insurer plunks the money in what amounts to an investment grade bond portfolio, earns a ~2% spread, and bob's your uncle. Its a little more complicated than that, but when you see a life insurer, think "finance company/bank with hairier regulation".

 

[cute fuzzy bunny]

How did you know I have an uncle named Bob?

 

[Gearhead Jim]

Here is the FIREcalc data that I promised yesterday.  Please remember:
1.  The numbers in this example (except age) are not my numbers (privacy), but are for illustration.
2.  Any use of FIREcalc requires one to make a lot of assumptions, which will greatly affect the final results.  Don't bother to snipe at the assumptions used in the example, they are reasonable for some folks but not everyone.  The only one I will defend is the 40 year retirement for a 60/58 year old couple.  Current statistics (NOT allowing for further improvements in mortality or the fact that the averages include chain-smoking sharecroppers with no medical insurance) say that a 65 year old couple has something like a 20% chance that at least one of them will live to be 97. 

Here is the basic scenario;
Couple 60/58 years
Want $100k yearly income, adjusted for CPI
Portfolio of $1,500,000
40 year retirement
His SS $18K in year 3, her SS $8K in year 5
Fixed (non-indexed) pension of $30k
Portfolio is 50/50 stocks/bonds
TIPS average 2.0 (that seems to effect the bond results)
Bonds are 5 year treasuries
1% expense ratio overall

Invested as above, they have an 87.9% chance of success
Put $200k in the Vanguard inflation-indexed annuity, success rate is 88.6%

Or to put it another way, the 100% SWR is:
$91,050 if invested as above, $91,910 if $200k in the same inflation-indexed annuity.

I could not find ANY case where investing in an immediate FIXED annuity seemed to help, only the inflation-indexed version seemed useful.

Does this mean we should all run out and buy the Vanguard inflation-indexed annuity?  NO!
Am I going to buy one?  Not right now, maybe never.
But my point is that all the shreiking over how bad annuities are, ignores the possible use of one that is inflation indexed.  What we need is:
1. More time for more people to do rational analysis of inflation-indexed annuities as a part of the overall portfolio, and
2. Less emotion.  Or the honesty to admit that some of our investment decisions are emotion-driven.

 

[cute fuzzy bunny]

I think your scenario demonstrates both the benefits of an income stream to the portfolio...regardless of where it comes from...and thats a good thing. The firecalc analysis I did involving taking SS early vs late also showed that the sudden appearance of a reliable income stream during retirement allowed one to spend more money throughout ones life and still be 'safe' by firecalc standards.

The analysis also shows how some different ways to plan help offset concerns about living a longer than 'average' life span. Just make sure you do the numbers for whatever lifespan you think YOU'LL live as a function of your lifestyle, relative health and genetics. If everyone in your family leads a moderately healthy lifestyle but dies in their 80's, shortchanging your spending earlier in life 'just in case' might not be your best bet.

Emotionwise, I think a lot of people like to say they invest unemotionally. Let me see how the cute and fuzzy bunny would politely phrase this...uhh...they're ****ing liars? No...thats not it...they are emboldened by good times but would probably not hold up against a tough investing market without doing SOMETHING that may end up doing more harm than good...yes, thats the proper CFB approach...

The problem with annuities are several fold. One is that a couple of annuity salesmen have blown through here over the last couple of years, and both turned into flaming trolls when people asked actual questions with the expectation of getting reasonable answers. Which never came. A few discussions have been the typical "My opinions are as good as facts, just dont ask me to quantify them or agree that they're only my opinion or I'll call you names and become an a-hole".

And anything thats highly dependent on an intangible like how long you're going to live coupled with trying to figure out how your spending will change as you age...is just asking for trouble.

So its an implausible question to answer in any generality at all, in fact its hard to answer for yourself if you know everything thats knowable and keep all the predisposition out of it.

Add that to the pre-marinated group thats been exposed to some very unpleasant discussions with regards to the topic and you've got a tough row to hoe...

 

[lwbarry]

It's been a while since this thread died down, but I wanted to come back and thank everyone again for the discussion. I'm staying extremely busy lately between work and school, so I don't have nearly as much time as I'd like to read and participate in this board. This has been my first chance to come back to the board in a while.

I've done a bit more thinking on this topic since we had this discussion. I continue to agree with most of you that annuities, in general, are a bad way to go.

On the other hand, this is completely theoretical since I'm not working as a financial planner yet, but I could see some clients wanting a guaranteed income stream even after I educated them that they would get a better return, and be able to keep the principal, by taking systematic withdrawals from their investment portfolio. (There is still the risk that the insurance company will fail, and I'll definitely let clients know this, but for better or worse, insurance companies are allowed to use the word "guaranteed.") In other words, from a purely financial/academic perspective, annuities are a bad deal and no one should ever use them. However, when you put the human element/desire for security into the situation, some clients may decide an annuity is worth the tradeoffs.

Basically, the way I am leaning toward dealing with this issue with clients in a situation where an annuity could make any level of sense (this would certainly not be all situations; each situation is unique), is to say something like:

1. Using your investment portfolio will give you a higher expected return, due in part to much lower fees and expenses, and will allow you to keep the principal, etc. etc. (all the reasons to use your investment portfolio that people on this forum espouse and I completely agree with). Therefore, I lean toward using your investment portfolio whenever possible.

2. That said, an annuity does provide an income stream you can't outlive, subject to the caveat that you are depending on the insurer not to fail, which is why you would only want to use a very highly rated company. If we decide an annuity makes sense for your situation, I'll work with you to find the lowest-cost alternative possible, e.g. something from Vanguard.

Once again (in the same spirit as my original post), I'm putting this out there to expose my current thinking to you, in the hope that we can enrich each other's thinking through discussion. And, recall that if if/when I do work as a planner, it will be on a fee-only basis where I have no financial incentive to use annuities.

Best, Leonard

PS As Brewer noted, keeping up with the literature can yield good insights. I did a quick search for useful articles on the subject of using your investment portfolio vs. using an annuity. Here are a few (citation plus a short summary). I can’t post the actual articles due to copyright restrictions.

Dus, Ivica; Maurer, Raimond; Mitchell, Olivia S.. Betting on death and capital markets in retirement: a shortfall risk analysis of life annuities versus phased withdrawal plans. Financial Services Review, Fall2005, Vol. 14 Issue 3, p169-196.
(My summary: Phased withdrawals from your own portfolio are better than an annuity if you know what you’re doing and you are willing to invest the time. This is consistent with the thinking on this forum.)

Milevsky. M. (1998). Optimal asset allocation towards the end of the life cycle: To annuitize or not to annuitize? Journal of Risk and Insurance, 65, 401-426.
(From abstract of paper: We propose a model in which retirees defer annuitization, via a "do-il-yourself" scheme, until it is no longer possible lo beat the mortality-adjusted rate of retum from a life annuity. We make use of a unique Canadian databa.se to calibrate the insurance loads and interest rate parameters. We conclude that in the current environment, a .sixty five year old female (male) has a ninety percent (eighly-five percent) chance of beating the rate of retum from a life annuity, unlii age eighty.)

Milevsky, Moshe Arye; Panyagometh, Kamphol. Variable annuities versus mutual funds: a Monte-Carlo analysis of the options. Financial Services Review, 2001, Vol. 10 Issue 1-4.
(My summary: very low cost variable annuities—under 10 basis points which obviously excludes the vast majority—are found to be better than low cost mutual funds when the time horizon is at least 10 years.)

 

[brewer12345]

lw, I think that your proposed way of dealing with panicky clients is reasonable. If you strongly caution them against annuities and they insist, well, you have done your fiduciary duty. I would suggest that in addition to VG, you could look to TIAA-CREF and USAA for annuities. Both of these companies are extremely financially secure and have a very long track record of treating policyholders well. They also will sell low cost products direct to the consumer (no commission to pay).

BTW, Milevsky is probably the foremost researcher in this field.

 

[lwbarry]

Thanks Brewer, nice to hear from you again. I'll add TIAA-CREF and USAA to my list. I knew they were good companies in general but didn't know they had annuity offerings.

Best, Leonard

 

[New Thinking]

Leonard - I would disagree with your statement "In other words, from a purely financial/academic perspective, annuities are a bad deal and no one should ever use them." Many academics including Olivia Mitchell and Moshe Milevsky have presented why many retirees should consider immediate annuities..Basically, the longer one lives, the higher the rate of return one has to earn to make the money last..The "mortality premium" that a retiree pays allows him/her to receive a higher rate of return on their investment if they live a longer retirement..The mortality premium being the fact that you give up your claim to your investment if you die..Instead, the earnings on that investment are shared amonst the remaining living retirees..Don't dismiss immediate annuities so quickly..Part of the problem with the financial planning profession is that nearly everyone is recommending a "wealth management" approach.."Let me manage your money for you and I will do much better"..In the meantime, they charge 1 - 1.5% per year and then the underlying funds also have expense charges and trading costs..This is "strategy" will cause more retirees to run out of money than the use of immediate annuities will - IMO.....I am curious though..when you say "fee-only" do you mean "fee-based?? Are you planning on charging an ongoing fee on the assets you manage or a one-time fee/hourly charge?? If you are going the latter approach, you will need a lot of good fortune to make a career out of it..It is just the nature of the beast that you will most likely struggle to get people "in the door"...This is the great challenge of the profession and why so many planners "sell product"..They need to put food on the table to stay in the business. Good luck with your career!