It was a good week for schools in the Austin area. Several school districts passed bonds and a couple made adjustments to their tax structure, known as "Golden Pennies", that will allow them to retain more of their local tax money. All the measures should help provide better facilities, staffing, and learning opportunities for the students in those districts. But while some districts found gold, many teachers and district employees across the state may still be getting the shaft.
“I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail,” said the famous psychologist, Abraham Maslow in his book The Psychology of Science. He was referencing drug treatments for certain mental illnesses, but could have just as easily been referring to annuity salespeople. Prominent personal finance writers frequently rail against the inappropriate use of these products. There are even advisory firms that market their services by explaining why they “hate” annuities.
Why all the fuss? If insurance companies only offered straightforward annuities such as I describe below, there probably wouldn’t be much controversy. It’s the myriad of options and marketing tactics that confuse people as to what they are getting or what they may be paying for it. Today, I’d like to discuss the basic form of annuities and provide an example of where they MAY be used appropriately.
Annuities have been around since the Roman Empire. Even the word annuity is derived from the Latin word, “annua” which referred to contracts that made annual payments. Annuities, in their basic form referred to as immediate annuities, still offer a contract that trades a lump sum of cash for a stream of payments that can last for specific periods of time or even for a lifetime. Insurance companies use a combination of actuarial calculations and current interest rates to determine how much they are willing to pay out. Immediate annuities are most commonly used to provide an income similar to what a pension plan may offer, to payout certain judicial settlements, or just to spread out payments over a period of time.
For comparison sake, an investor can and should shop insurance companies of similar credit quality and compare payouts to determine where the best deal may be. This is a fairly straightforward concept and represents a viable solution when an investor needs to provide for expenses that are non-negotiable, such as food and shelter.
The big tradeoff for receiving this guaranteed income stream is lack of liquidity. The downside of which can be observed on daytime television as actors or even opera singers implore you to call if you need “cash now” for your annuity or structured settlement. You can bet that the lump sum payment they offer someone willing to trade for their future payments will be at a significant discount, which is why you should only put money into one of these products for income that you can’t afford to do without.
For an example of where an immediate annuity may be attractive, let’s consider a 65 year old retiree with a $1,000,000 retirement account. Let’s say the retiree wants $40,000 a year, or 4%, of income from his account, and that half of that amount is needed for essential expenses.
Option 1: According to my financial planning program MoneyGuidePro®, a 65 year old man could invest in a balanced portfolio of 60% stocks and 40% bonds and have a 68% probability of success of withdrawing 4% per year adjusted for 2% inflation for a life expectancy to age 90. In other words, in 32% of the simulations, our investor would run out of money by age 90.
Option 2: According to Fidelity Investments Guaranteed Income Estimator, the same retiree could generate a lifetime income of $20,000 per year with a 2% inflation annual adjustment, for $381,769 in an immediate annuity. He would then have $618,231 left to invest in the same balanced portfolio, but would only need to withdraw 3.2% to generate the additional $20,000. The probability of success increases to a 90% chance through age 90.
The catches are that when he dies, the $381,769 goes to the insurance company or if he needed additional funds for current needs, he would likely be offered much less than his original investment in a lump sum. If he gets hit by a bus tomorrow, the insurance company wins. If he lives past his actuarial life expectancy, he wins. Pretty straightforward and simple. Additional guarantees can be bought to insure the payouts last for a specific period of time or for beneficiaries to continue to receive the income if the original recipient dies, but the costs of those guarantees may make the comparison less compelling.
Where does it get complex? When marketers start trying to take this simple concept and make it appear that you can get a free lunch. There are a myriad of annuity types that aren’t simple nor are they straightforward. If you want a taste of just how complex these products can be, try doing a web search with the terms “FINRA” and “Annuity”.
What they virtually ALL have in common is complexity, additional fees, and that they are not bought by investors. Instead, they are SOLD to investors. Keep that in mind if you are pitched one of these products next time you mention to your banker or broker that interest rates are low or that tax rates are too high.
If you would like to review your situation to see what your odds of success currently look like, please contact me to schedule an appointment.
Did you hear about the Aggie scientist that developed a three-legged chicken?