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[I hope if I made any mistakes here someone will tell me so I can fix it.]
Annuities come in two flavors. An immediate annuity (which is what we have been discussing on this board) begins to pay you very soon after you purchase it. A deferred annuity holds and invests the money until some future time when it will be converted to an immediate annuity and begin payments.
Annuities are paid in one of two ways. A fixed annuity pays a set amount of money each period (usually monthly). A variable annuity pays a different amount of money each period (usually monthly) based upon how well or poorly its investments are doing.
Annuities are complex beasts and can be confusing. First, you have to change your thinking. You are not investing your money. You are not trying to “grow” your assets and become richer. Instead, you are trying to prevent yourself from running out of money before you die. You are making sure that you have a certain amount of money coming to you on a regular basis. You are creating a pension. So, this is an entirely different purpose than investing. An immediate annuity will not make you richer. It is not intended to keep up with inflation (although it will help) but it will keep you from running out of money.
For example: Mr. Smith and Mr. Jones both have $100,000 in their respective savings accounts. Both are 65 years old and both receive $2,000 in social security benefits monthly. Both have monthly living expenses of $2,400. Mr. Smith has bought an immediate annuity. He will receive $416 per month from his annuity for his entire life. In this example to make my life easy we will assume that there is no inflation and that savings accounts earn no interest. Mr. Smith will not ever have to worry about not being able to afford his monthly expenses for life because between social security and his annuity he is receiving $2,416 monthly. Mr. Jones did not buy an annuity. Every month Mr. Jones goes to the bank and withdraws $400 to add to his social security benefit in order to pay his bills. After 20 years and some months of withdrawing $400 a month Mr. Jones has nothing left in the bank. If Mr. Jones lives to be 85 he is going to have to live on only $2,000 social security because he has nothing left to add to it. He will have to hope that he can do that.
To buy an immediate annuity, basically you give an insurance company an amount of money. The insurance company is going to do some calculations based upon your age and the prevailing interest rate. Their actuaries are going to figure out how long they think you are going to live. They are then going to give you back the money that you gave to them in installments that coincide with the length of time you are expected to live. This is called the Annual Payout Rate and should not be confused with the interest rate. This has to do with the length of time the insurance company thinks you will live and consequently how long they will have to pay you.
For example: Mr. Smith, a single man, is 50 years old (an arbitrary name, an arbitrary age) when he approaches an insurance company to purchase an immediate annuity. For this example we will guess that according to the actuaries a 50 year old man is expected to live until he is approximately 70 years old. The actuaries will then conclude that the payout rate is 5% (which translates into 20 years). Mr. Smith gives the insurance company $100,000 (an arbitrary amount) for his annuity. Mr. Smith will receive 5% of $100,000 or $5,000 per year ($416.67 monthly). In 20 years he will have received $100,000. If Mr. Smith dies at age 70 he will have received all of his money back. If Mr. Smith lives until he is 80 he will receive $5,000 for 30 years. He will have received a total of $150,000. This is $50,000 more than he gave the insurance company initially. If my math is correct (and I am notorious for miscalculating compound interest), in effect, his money would have grown approximately 1.35% over those 30 years. Mr. Smith doesn't care about that. What he cares about is that he didn't run out of money at age 70.
The payments you get back will be determined by a number of factors: (1) whether you have chosen a “fixed” or “variable” annuity. The “fixed” immediate annuity will pay the same amount each month. The “variable” annuity will fluctuate based upon market conditions; (2) how often and for how long you are paid. You can choose to be paid monthly for life. You can choose to be paid monthly for 5 years, you can choose to be paid quarterly, etc. Because insurance companies want to make sure they sell as many annuities as they can, they make sure to be very flexible on their options; (3) the extra options you add to the annuity. The more options you add, the less you will receive in each payment because theoretically the annuity will have to stretch for a longer period of time. Options are things like: [A] How long the annuity will last for (i.e. your lifetime, 5 years, 10 years, 15 years, etc.) [b] If your annuity has a payout to a beneficiary, [C] how many lives the annuity is covering (single vs. joint), [D] whether there is a guaranteed payment amount even if you die.
The insurance company is going to take the money that you gave to them, pool it with money other people have given to them, and they are going to invest it more aggressively than you would invest it. It is their belief that they will invest it well enough to be able to pay you the guaranteed monthly installment until the day you die. It is also their hope that you don’t live very long.
Annuities work a lot like Social Security. With Social Security you pay your money into the system from each paycheck. You have no control over that money. The Social Security funds are pooled and invested. Some people live long enough to receive all of the money they paid into Social Security and more in the form of a monthly benefit. Other people die at a young age and never receive any Social Security benefits. Their money remains in the pool of funds and is used to pay other people. Your heirs do not get your social security funds back if you die before they are disbursed to you. Annuities work the same way. You are guaranteed a monthly amount while you are alive. When you die payments stop. If you didn't get all of your money back, it will remain in the pool and be used to pay other people. Some people don’t like this idea so they buy an option which will allow their beneficiary to receive the monthly payment until all payments equal the initial premium or until a certain number of years have passed. If you choose these options, your monthly payment will be reduced.
As noted above, the amount of the monthly benefit is determined based upon your age when you buy the immediate annuity and the prevailing interest rate. If the annuity has to cover fewer years you will get a higher percentage back in your monthly payment. If you buy the annuity during periods where interest rates are high, you will also get a higher monthly payment.
For example: Mr. Smith is 50 years old when he buys the $100,000 annuity. In the example above it is going to have to cover him for 20 years until he is 70. He will only receive $5,000 a year. If he buys the annuity at age 70 and it is calculated that since he lived to age 70 statistically he is going to live until he is 82 (arbitrary age), he will be paid $8,100 per year because now it only has to cover 12 years. So, the later in life he buys it, the larger his monthly payment will be. That is the reason that people are suggesting waiting until later in life to purchase the annuity. Also, interest rates are low now but they may increase eventually.
On the positive side, you are guaranteed to receive a set amount of money periodically (usually monthly) until you die. As with all insurance products, each state has a guarantee fund established to protect policy owners in case the insurance company becomes insolvent. You need to check with your state to see up to what value the guarantee fund will cover. Each state is different.
On the negative side, once you buy an annuity you lose control of that money. Also, it is close to impossible and/or very costly to break an annuity. If you die before you receive all of your money back, you cannot leave it to a beneficiary if you didn't purchase that option. If you have an emergency and need extra cash from the annuity, you will have to sell the annuity at a discounted rate to get it. Therefore, don’t put all of your money into an annuity. Save some for a rainy day.
Years ago I purchased a deferred annuity. This is how my deferred annuity works: Mr. Smith age 53 (an arbitrary name, an arbitrary age) gave the insurance company money. For this example it is the $100,000 (an arbitrary amount) that I used in my previous examples. This money is called the contract value. The insurance company has invested it in a portfolio of stocks: 24% is in Aggressive Growth, 15% is in Growth, 33% is in Growth and Income, and 28% is in Income funds. The value of this account is going to increase or decrease as the market fluctuates daily. This is what is happening to his real money.
The insurance company is guarantying that Mr. Smith will earn 7% *** annually for 7 years on his initial $100,000 investment. So every year his $100,000 initial deposit is increased by the interest (just like what happens if you put money into a savings account at a bank). This will continue for 7 years. This figure is called the Benefit Base. In 7 years the benefit base will be $134,578. This is not real money because Mr. Smith's money was not put into a savings account and is not really earning interest. This is just done for accounting purposes so that both the insurance company and Mr. Smith know what his guaranteed income will be over time.
*** The insurance company is charging Mr. Smith 2.75% of his contract value annually to manage his account. Therefore, the net rate of interest over 7 years will be 4.25% (7% - 2.75%). They don't make this entirely clear when enticing you with the 7% guaranteed interest. It is the net 4.25% that is used to calculate the Benefit Base.
In 7 years Mr. Smith will be age 60 and can start withdrawing his annuity benefits. He will do this by converting it to an immediate annuity.
In 7 years when Mr. Smith will start withdrawing his annuity benefit the calculation will be based upon the Benefit Base. He will be allowed to withdraw up to 5% annually which will cover 20 years of his life (because that is how long the actuaries think he will live) before it is exhausted.
Example: At the end of 7 years the Benefit Base is $134,578 because that was the guaranteed 7% (4.25% actual return). The contract amount may be more or less money because that money is subject to the fluctuations in the market. (For this example we will assume that the market did well and his initial investment [contract value] has increased to $200,000). The actuaries are going to figure out how long they think Mr. Smith is going to live based upon the age when he started the annuity. Since Mr. Smith was 53 when he started the annuity, their actuarial tables show that Mr. Smith should live to be 80 years old. They calculate that this means they will be paying him for 20 years if he takes benefits at age 60 and thus he can withdraw 5% per year. Mr. Smith was promised $6,728 annually (134,578 x 5%). If you divide 134,578 by $6,728 the answer will be 20 years. This means that they can pay Mr. Smith $6,728 for 20 years (to age 80) before his "benefit base" will be depleted but his contract value will still have $65,422 in it ($200,000 - 134,578 paid out monthly over 20 years). If Mr. Smith lives to be 89, his contract value ($200,000) will be depleted and the insurance company will continue paying Mr. Smith $6,728 until he dies. At this rate he would have to live to the age of 90 before the insurance company has to dig into their reserve funds of people who didn't live to exhaust their own funds or who haven’t started to receive their payments yet (this is the same way Social Security operates). If Mr. Smith dies before using up the entire $200,000 of his contract value the remaining balance will remain in the pool of funds to be used to pay other annuitants.
Example 2: At the end of 7 years, the initial deposit (contract value) of $100,000 has decreased to $90,000 because the market performed poorly. The Benefit Base is $134,578. Mr. Smith is receiving $6,728 monthly. At the end of 14 years he has been paid more than the amount in his contract value account ($90,000). He will be 74 years old and he will continue to be paid $6,728 until he dies. If he dies at age 80, he will have received 4.25% on his investment of $100,000. If he dies at age 84, he will have received the guaranteed 7%.
The insurance companies are betting (1) that their statistical tables are fairly accurate, (2) that you will not live long enough to outlive your money based upon their calculated distributions, and (3) that they can invest your money aggressively and correctly to cover your needs.
They are stacking the deck in their favor by charging a hefty surrender value plus additional fees in order to end the annuity early and by charging high fees to manage your money. For this reason, many people prefer to invest in ways that have lower management fees and then purchase an immediate annuity later in life.
annuities work best when combined with your own investing.
if you think of the stock market it is filled with peaks and valleys . selling equities when they are down for extended periods of time is killing the goose that lays the golden egg.
even when markets bounce back you end up with less bang for the buck since you had to overspend to draw income when things are down.
with an annuity you are buying a pension plain and simple.
that consistant cash flow fills in those valleys making for a smoother ride .
it also can provide higher levels of income then you can get safely on your own allowing you to free up more cash for investing in equities for higher growth.
right now you can get a 6% withdrawal rate at 65 from an annuity vs 4% from 30 year bonds.
that is 33% more income and less money needed allocated to lower paying investments.
in fact buying an immeadiate annuity and going 50-75% equities on your own has been shown to leave a bigger nest egg over for heirs if you live long enough than not buying the annuity and going only on your own investing.
the reason is with the pensionized income coming in you are less likely to have to draw down on equities and you can reinvest dividends and let the equities grow longer without being touched as much..
research by dr wade pfau and michael kitces just completed a joint study on this. they found a retiree would have to increase their stock allocations by 1% a year every year in retirement to duplicate what the annuity/investing on your own accomplished.
not many retirees want to go that route.
deferred and variable annities rarely work out in your favor. they are very complex,fee and commission filled and full of twists and turns. even with fidelity and vanguards low cost annuities you have to be careful.
fidelity's is lower cost but has no death benefit. you would have to add life insurance to equal most other plans. based on the historical average returns for say a 60/40 mix in their variable annuity between fees and draw down the odds are you can never really hit that high water mark they talk about .
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Last edited by mathjak107; 10-05-2013 at 11:38 AM..
clb, a Single Premium Income Annuity (SPIA), or a Deferred income annuity (which is modeled on the SPIA) are low commission, no fee products. They are not investments. They are an insurance product that guarantees a monthly cash flow that you will never outlive. There are riders that can be added so that your heirs can inherit the annuity funds. Annuities will cover joint or single life.
A portfolio of dividend paying blue chip funds is an investment. The value of the blue chip dividend paying funds will rise and fall. The amount of dividends can go up or down. There is no guaranty as to how much income it will generate each year. There is no guaranty that you will not outlive those funds.
An annuity is supposed to be used in conjunction with investments. In this way you have both the guaranteed income and a hedge against inflation.
People seem to want to confuse insurance and investment. They are different products that do different things, but with them working together you have a good plan for retirement.
Wouldn't of portfolio of dividend paying blue chips that raise their dividends each year be better than an expensive annuity for retirement?
This argument has been debated ad nauseam. There are obviously two sides to this. One side will say annuities are good and cherry pick statistics to back up their claim. The opposing side will say annuities are bad and they too will cherry pick statistics to back up their claim. And so the argument continues.
The one constant, however, seems to be, if you do purchase an annuity, never tie up all of your funds in one. Try to keep some money for emergencies.
Personally, I think the biggest advantage to an annuity is the peace of mind one has. Studies show that those who purchased an annuity are happier in their retirement than those who decided to rely on the stock market. It only takes a major market downturn similar to what we saw in 2008 to make one realize how tenuous the market can be. While it's true the market always comes back after some time. However, retirees may not have time on their side.
the annuities are best used as a proxy for your cash and bonds portion of a balanced portfolio , they are not for replacing equities and or dividend paying stocks. not the same thing at all. you need those regardless.
even variable annuities are not good as an equity replacement.
Very much appreciate you taking the time to write this up and post it. Very informative.
I do have a question; when the actuary wizards calculate how long they expect you to live, do they consider your current medical condition? Or, just go by tables of averages?
usually annuity products are only bought by healthy people. it would be a mistake to buy one unless you got as much of the odds on your side as you can.
This argument has been debated ad nauseam. There are obviously two sides to this. One side will say annuities are good and cherry pick statistics to back up their claim. The opposing side will say annuities are bad and they too will cherry pick statistics to back up their claim. And so the argument continues.
The one constant, however, seems to be, if you do purchase an annuity, never tie up all of your funds in one. Try to keep some money for emergencies.
Personally, I think the biggest advantage to an annuity is the peace of mind one has. Studies show that those who purchased an annuity are happier in their retirement than those who decided to rely on the stock market. It only takes a major market downturn similar to what we saw in 2008 to make one realize how tenuous the market can be. While it's true the market always comes back after some time. However, retirees may not have time on their side.
Blue chips like Pepsi and Aetna almost NEVER cut their dividends.
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