By Brad Thomason, CPA
Today we’re going to talk about annuities and the people who buy them.
Quick point of clarification: I’ll be discussing fixed annuities, not variable annuities. Variable annuities are a hybrid insurance product and registered security, all wrapped into one. They are often hopelessly complicated, and frequently maligned because they tend to have high fee structures. By contrast, fixed annuities are not exactly the simplest things in the world; but they are nonetheless pure insurance contracts that don’t seem like they are trying to be the Swiss Army knives of the financial product world.
A fixed annuity is an agreement with an insurance company to receive income in exchange for a lump sum (or in some cases, a series of payments). Because these are multi-year commitments, there is always some sort of interest being paid, in one form or another. Frequently there are multiple payout options for a particular contract, at least at first glance. Substantively however, there are really only two options: income for life, or income for some shorter period of time (of which there may be more than one shorter period offered).
Understanding what is going on here is fairly simple if you recall that the reason insurance exists in the first place is to transfer risk away from the person paying for the insurance.
People who select to receive income for some period less than life (e.g. once a quarter for ten years, monthly for five years, etc) are essentially taking out the contract in order to collect interest. The rate on annuities is frequently higher than for CDs and Treasury Bonds, so the risk being shifted is the risk of being able to find something that pays a higher rate. Insurance companies have money managers, bond traders, and so forth already on staff. By taking out the contract, the annuity purchaser is essentially getting access to the work these people do, rather than having to do it (or find someone to do it) themselves.
However, people who choose the income-for-life option are addressing a very different risk: the risk of living too long and running out of money.
Let’s say that a 65 year-old person expects to have enough money to live on for the next 20 years. On the one hand, that’s a good thing. Twenty years of apparent security is a lot more than most people have. Then again, people can and do live past 85. What happens then?
Well, if the person owns an annuity for which the life income option has been selected, the annuity payments will continue past 85. The insurance company will be legally obligated to keep paying out as long as that person is alive, just as they are legally obligated to replace a car if it gets stolen, or a roof if a tree falls through it. In the more extreme case, where the person lives another fifteen or twenty years past 85, he/she will continue to receive income far in excess of what the original savings amount could have (safely) produced had the annuity contract not been entered into.
Again, the thing that is being insured, in this case, is the risk associated with living too long. Which may be a very expensive proposition, depending on how long it lasts.
What happens if the person doesn’t live past 85? Same thing that happens if no one steals your car or all of your trees behave themselves. The insurance company keeps the premiums, and you had years of peace of mind of knowing that they were on the hook if the bad thing happened.
So those are the two basic uses of annuity contracts (with numerous variations on the themes, accepted).
When you articulate a pair of options people inevitably ask you which is better. In this case, there isn’t an answer to that question; at least not in the spirit that the question is posed. Think of annuities, instead, as a tool capable of doing a couple of different jobs. If you are in the market to complete either one of those jobs (i.e. interest earnings, or income you can’t out-live) then an annuity contract is a tool you want to take a look at. It might be the best tool for the particular job that you are interested in, and even if not, it might be a sensible one to use alongside some of the other financial instruments/products out there.
By Brad Thomason, CPA
Do you remember the Six Million Dollar Man? Even though I was a kid at the time, it was not lost on me that such a sum was supposed to be essentially incomprehensible by a normal human. Later, when I was in high school, I have a vague recollection of someone associated with the military (a recruiter, I guess) pointing out, in the afterglow of Topgun, that six million is about what the US government had to invest to get a fighter pilot all the way trained. I think he told us that because he was trying to impress us. I don’t specifically recall; but I bet it worked.
Well, times change, and amounts which once seemed titanic have a way of becoming more mundane. Six million dollars is still many, many more dollars than I would want to fork over for a barbeque sandwich. Even with the sides. But it is no longer a number so big that one simply can’t wrap the old head around it. You may not have six million dollars. But the mere idea of it doesn’t utterly boggle the mind the way it did when Lee Majors was jumping around with that springing sound in the background.
I was thinking about all of that because the other day I was doing some modeling for a client, and it turned out that over the period of time we were looking at, the investment portfolio was going to need to generate about six million for the plan to work.
Now, before you start thinking that this guy must be super-rich and has a massive annual budget to go with it, I’ll go ahead and tell you, he isn’t and he doesn’t. I can’t give you any personal details, of course. But his request was more in the form of “what would it take?” rather than “what should I do with my actual savings?”
So since it was a hypothetical in the first place, I can give you the broad strokes.
There were two basic questions. The first, if a 55 year old needed an income of $120K a year (today’s dollars), what would that look like by age 70 if inflation were three percent every year? Second, assuming some Social Security, and investment performance of 7% pre-retirement and 4% post-retirement, how much starting capital (i.e. at 55) would it take to fund that scenario all the way to age one hundred?
So we grossed up the income, entered the other assumptions, and regressed the matter back to the conclusion that the balance at age 55 would need to be about $1.5 million.
That’s sort of a simplistic way to look at the matter, and if we had been trying to do more than satisfy a curiosity, we would have used additional methods, looked for corroboration and generally sought to fine tune where we could. But for this assignment, the basic route was enough to provide the necessary approximation.
While looking at the year-by-year results, we also took a look at the total investment earnings over the period. Over six million dollars, as I mentioned earlier.
Let me state that a different way: the whole exercise was going to cost just shy of $9.5 million. Being alive for decades ain’t cheap, even if you aren’t being extravagant. Of that total, the initial capital amount plus all of the Social Security was going to take out about $3 million of the total. So the investments were going to have to earn the rest.
The reason I’m pointing this out is because it is very easy to think of investment returns as just some percentage number you drop into a spreadsheet that serves to make the totals end up where you want them.
But investment returns represent actual dollars that have to be made, one way or the other.
Are you thinking of retirement in terms of “what do I need to be doing to earn six million dollars?”
In some respects the whole reason you want investments is because you don’t have to do anything for them to make money. But that, too, is just a touch simplistic for the real world. You might not have to toil in the field to make the dividend or interest payment spring into being. But you do have to be diligent about keeping the capital deployed, and thoughtful about where you put it, so that the risks inherent to the particular investment don’t lead to more exposure than your situation can reasonably abide. Investment capital represents productive capacity, but it is up to you to steer it to the places where the production can occur.
So yea, what’s your plan to make six million dollars (or whatever your number is)? I think that is a pretty good thing to think about, man.
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