$tarrBuck Report for August 6, 2006: Immediate Annuity?

August 6, 2006

$tarrBuck Report for August 6, 2006: Immediate Annuity?

by

R. M. Starr

An immediate life annuity is an insurance product that pays you a regular income for life, in exchange for a lump sum to purchase it now. It’s the precise opposite of life insurance — life insurance insures you against dying too soon; a life annuity insures you against outliving your money.

You pay for an immediate annuity now and it starts paying off directly, a check next month and each month thereafter. That makes it a lot simpler and more reliable than a deferred annuity (which starts paying off in the distant future) or a variable annuity (whose payoffs are keyed to the stock market).

Hammond Blackwell has managed his own money throughout his life. At his next birthday he’ll be 70 years old. Hammond’s mother just celebrated her 97th birthday. Hammond hasn’t been planning to live to 97 — but in case he does, he’d like some income security. He’s looking into buying a life annuity as a 70th birthday present for himself.

Hammond gets a quote from an insurance broker: For $500,000 now, Hammond can receive a monthly income of $3800 for life. If he lives as long as his mother, Hammond can receive $1,230,000, more than twice as much as his cost. But that calculation ignores the time value of money. Long term high grade corporate bonds are currently paying 6% annually. At that rate, $3800 per month for 27 years is currently worth about $600,000, more than Hammond’s cost but not such a bonanza. Nevertheless, that would be a good, and profitable deal. To do this bit of figuring Hammond could use the NPV function on Excel or go to http://www.moneychimp.com/calculator/retirement_calculator.htm .

But Hammond is not likely to live to 97. He looks up his life expectancy at http://www.cdc.gov/nchs/data/nvsr/nvsr54/nvsr54_14.pdf . At age 70 he’s likely to live another 13.5 years. At that rate, for his $500,000 he’ll collect $616,000. That’s more than it cost him, but actually, considering the time value of money, that stream of payments for 13.5 years is only worth $415,000. Insuring against outliving his money is costing Hammond $85,000. Is that too much? The break-even life expectancy is 18 years, 4.5 more than average.

There’s a reason it costs extra to buy the annuity. Not everyone buys one. People who don’t expect to live very long don’t buy annuities. So the life expectancy of the average annuitant is longer than the general population’s. For the insurer to break even, the annuity has to be priced assuming Hammond will live longer than the average American man. For the average American with an average lifespan, an annuity is not a financially winning investment.

Saving for retirement
There’s always the alternative of saving, investing and spending income and some principal. Hammond can create his own annuity plan. For $ 500,000 over 27 years, Hammond figures he can arrange a monthly income of $3150. That’s less than the annuity, but he’d maintain control. Or he could start with $600,000 and maintain the payout of $3800 for 27 years. But what if he lives too long? Mom is still going strong at 97. That’s the insurance value of the life annuity; it goes on as long as you do.

Waiting to buy the annuity
The longer you live, the shorter your remaining lifespan. If Hammond waits to age 80 to buy his annuity, he can get the same stream of payments for $350,000, and that’s in money a decade from now. If it’s earning interest in the meantime, it’s costing less in today’s dollars.

What about Inflation?
Even at moderate inflation rates, the value of $3800 a month can be cut in half over 27 years. It’s hard to find an annuity with a cost of living escalator. There are annuities available with a monthly payment that grows by a fixed percentage each year. But the starting monthly payment is reduced to make up for it. Not a good deal. To handle inflation, recognize that the purchasing power of the monthly payment is going to go down: save part of each month’s income in the early years recognizing the need to supplement the annuity later —- or plan to buy a second annuity (and set aside money for it now) in the future.

Choose your insurer
When you buy an annuity, you want to insure your future. The insurer had better be there then too. Choose a financially sound company; check it out in Best’s pocket key rating guide: Life-health, available in major libraries.

Happy Birthday, Hammond!

(c) Copyright R. M. Starr 2006

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