In my column last month, "An Unattractive Proposition," I outlined some of the reasons I believe clients do not seem to care for immediate annuities nearly as much as economists do. I received quite a few emails, and I thought I would share some of the "Yeah, but ..." comments I received with readers of Financial Advisor.
"Yeah, an annuity buyer disinherits their loved ones but for some that is fine, and no one has to put all their assets in one anyway."
Duh. Leaving an inheritance of any size to anyone may or may not be important to a particular client. Some people have no family or friends or causes to support. Others don't put these parties high on the priority list. Annuitization may indeed be at least part of their future.
I think most financial planners have heard some clients say that their goal is to have their last check, the one to the undertaker, bounce. Another common sentiment is that IF there is anything left over, sure, give that to the kids.
I delve into this every time it comes up and, without fail, the motivation behind these statements is that the clients want to enjoy their remaining time on earth more than they feel the need to leave something for heirs. They spent the first part of their life making money, now they want to spend their money over the rest of their life.
The steady checks from immediate annuities fit into this pretty well. However, their irrevocability, lack of flexibility and access to funds, and legacy of zero turn clients off. While immediate annuities are excellent at providing steady income, they are spectacularly bad at most everything else, so even a partial annuitization can be hard to implement.
When clients compare what they will get with an annuity to what they think their longevity odds are, the annuity doesn't look very good. I used the example of a low-cost contract that paid 5.6% of the purchase price for the joint lives of two 65 year olds. They won't even breakeven unless one of them lives to be 83 and after 30 years (age 95), the pre-tax investment return reaches only 3.74%.
If longevity is a real concern, paying to insure against that risk is more sensible. However, statistically, it is a simple fact of life and product design that most people are not expected to live long enough to make the insurance cost a great value.
The people I most often see pushing the idea of annuitizing are not insurance agents, but economists. They view the conversion of assets into income streams as a benefit to a society that has an underfunded and ill-equipped populace, particularly for workers with modest accumulations. This has a behavioral finance and a societal benefit angle I touched on in "Economist Love Them, Clients Hate Them" (February 2012 online column/March print edition).
"Yeah, immediate annuities aren't that good a deal, but longevity insurance is another matter."
Indeed.
The U.S. Treasury recently proposed a rule change that would make it easier to purchase longevity insurance products with 401(k) and IRA money without running afoul of Required Minimum Distribution Rules. The change should cause an increase in interest, though the proposed relief applies only to 25% of the account or $100,000, whichever is less.
In its most basic form, longevity insurance has many of the same characteristics as an immediate annuity. You send the insurance company, which you hope is sound, a check and get a lifetime income payment in return. You lose access to your funds and there is no inheritance unless you agree to smaller payments. Payments however, start later, usually between 80 and 85.
These products may be utilized more often than immediate annuities primarily because they require a lot less capital to assure a later-in-life income stream. Because the insurance company pays nothing for 20 years, it can put those funds in higher-yielding investments. According to one article, a 65-year-old man buying $50,000 in longevity insurance would get $28,600 annually for his life beginning at age 85. According to an estimator at Income Solutions, it would take about $424,000 to purchase a traditional annuity that would begin payments of $28,600 per year immediately.
From a purely mathematical standpoint the return can be very good for people with long lifespans but in a different form. Like immediate annuities, unless one lives long enough, the effect on net worth is negative. It will take almost 15 years (age 80) before the immediate annuity has returned the full $424,000. With immediate annuities, the longer one lives the closer the actual result approaches the initial payout rate.
With longevity insurance, if our buyer dies prior to age 85, his family gets nothing in return. If he makes it to 85, he gets the contractual payout for life. In that case, this is the same as a life-only immediate annuity paying $28,600 year. At current rates, 85 year olds can buy $28,600 for about $191,000. It looks like for $50,000, he gets something worth $191,000, but the income payments are only worth that to him at that moment if he is alive. He is not guaranteed to get that and can't get his hands on that amount, ever.
Sadly, I have seen these pitched as though the buyer gets a great return -- in this case 6.9% -- what it took for $50,000 to grow to $191,000 in 20 years. That is not an actual result. If he dies, after just one payment, all he got from his $50,000 would be $28,600. After two payments he is only $7,200 to the positive ($28,600 x 2 less $50,000) -- after 22 years.
However, the net result goes up considerably with each payment received. By the time the owner receives 10 payments, after 30 years at age 95, the return on that original $50,000 is near 7%. According to the Social Security Administration's 2007 mortality tables, life expectancy for a 65-year-old man is a bit more than age 82 and the odds of a 65-year-old man living to age 95 is roughly only 8%.
If one truly lives much longer than the mortality tables suggest, longevity insurance could provide a tremendous result, but if one's lifespan is not exceptional it will be a hit against the family' net worth. Offsetting that to some degree is the significantly lower amount of capital required to fund a later-in-life income stream.
"Yeah, immediate annuities don't pay a ton, but when interest rates rise they will be hot."
Maybe. I think this point has more validity with younger purchasers.
The way annuities are priced, interest rates affect payouts more at younger ages than older ages. For older buyers, mortality factors dominate. The exact numbers vary from chart to chart, but the general pattern persists. Increase interest rates for a 65-year-old male from 1% to 4%, and the cost of the annuity will drop about 26%. The same jump in interest rates for an 85 year old decreases the cost by only about 13%.
In addition, history shows few people bought immediate annuities even when they paid more. Interest rates won't change just for insurance companies. Other lower-risk alternatives to annuities will probably look more attractive, too. The 8%-plus payout rates a 65-year-old male could get in the recent past looks good now, but they didn't draw buyers when the market interest rates supported such a payout. The negatives I outlined exist regardless of the level of market interest rates.
So yeah, the primary purpose of an immediate annuity is to provide an income stream for as long as a person lives, and it does this very well. For some it will be a nice complement to their other positions. But, for most, these contracts' lack of flexibility, lack of access, and guarantee to make an insurance company an heir will continue to make them an unattractive proposition for most potential buyers.
Dan Moisand, CFP, has been featured as one of the America's top independent financial advisors by most leading financial advisor publications. He has spoken to advisor groups on five continents on topics such as managing investments and navigating tax complexities for retirees, retirement readiness, and most topics relating to the development of the financial planning profession. He practices in Melbourne, Fla. You can reach him at [email protected].