May 16, 2008

Is a fixed immediate annuity a good thing to buy?

Previously I discussed what annuities cost and what benefits they provide. But I didn't examine if its a good investment to buy one. So.. is it?

First of all lets discuss why you might want to buy an annuity. A fixed immediate annuity provides 3 key benefits: it provides guaranteed return with virtually no risk, it lasts for the rest of your life and it requires no work on your part.

But how does this compare to other options? For example you could simply put your money into CDs at a bank and roll them over annually. This would provide a guaranteed return with virtually no risk and very little work. So other simple investments are both safe and low work. But the annuity has the unique benefit that it lasts for the rest of your life no matter what your life span is. The difficulty in comparing an annuity to other investment options is accounting for the variable life span. We simply don't know in advance if we'll live for 1,2,5 or 25 more years.

How can we go about estimating the value of a lifetime annuity without knowing how long you'll live? We can only take a guess really. One way would be to determine the average remaining life span for the annuitant and then value the annuity for that period. For example, when you are 65 years old, your life expectancy is approximately 19 years. (from CDC data and additional CDC information source) So if we buy an annuity at age 65 then we could compare it to expenditures for another 19 years to cover the average case. This would only be the average case though and you may live longer or shorter. If you bought an annuity at another age then you would need to find the life expectancy for that age person.

The annuity we discussed previously bought at age 65 for a cost of $100,000 paid out $428 a month with inflation increases. We can estimate in the future inflation to be about the same as historical CPI average. The BLS has historical CPI data. From 1913 to 2008 the CPI inflation rate was 3.25% annually. If we start with $100,000 in the bank and pay out $428 a month with annual increases of +3.25% and also earn 3% on your savings then your balance will be depleted in a little over 18 years.

For a 3.25% inflation rate and starting with $100,000 balance at age 65, here is how long your savings will last in years based on savings interest rates of 3,4,5 & 6%:

Savings Rate 3% 4% 5% 6%
# Years Savings Last 18 20 24 29

If you can get a save 6% return then it would be a lot better off overall to simply invest your money on your own at that rate instead of getting an annuity. Bonds can historically give you returns of this level.

Another important consideration for annuities is the fact that generally with a fixed immediate annuity after the death of the annuitant and survivor there is no value left to the estate. On the other hand if you save your money on your own then anything left over can be passed in your estate. For example say you buy an annuity at age 65 for $100,000 with monthly payment of $428 and then you pass away 10 years later. After your death the money is gone and there is no value in the annuity. On the other hand if you had put your money into savings and gotten interest of 3% and paid yourself the same $428 a month with inflation adjustment and passed away after 10 years you would still have over $66,000 in your savings that would be left to your heirs.

What happens if you live a very long time? If you have an annuity then it will pay out for as long as you live. So if you live to be 100 then the annuity will still pay you. The longer you live, the more the annuity is worth. That $100,000 annuity bought at 65 would be better than a 6% savings rate if you live over the age of 95.

In my personal opinion I think overall the annuity isn't the better investment for retirement. However, if the certainty of guaranteed lifelong payments regardless of your life expectancy is important enough to you then an annuity might be your preferred choice. That's basically what it comes down to: whether or not the lifelong certainty is worth paying a premium for.

1 comment:

  1. I plan to place most of my funds into an immediate annuity at age 70. Then the whole question "will your nest egg last a lifetime" becomes moot as I get payments fo as long as I live. In retirement planning, people really only need to have their next egg last to age 70 with enouyh left at that time to by immediate annuities.

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