Recently, the business section of my local newspaper carried a column on the benefits of utilizing an immediate annuity as a source of retirement income. Just a few days earlier, an online retirement-focused article highlighted both immediate and deferred income annuities. As baby boomers without pensions continue to move into retirement, income annuities are increasingly mentioned as a means to create a personal pension.
While these articles are mostly positive about the benefits of these products, a significant number of them conclude that potential purchasers would be better off if they delay purchasing immediate and deferred-income annuities until after interest rates increase. But is that true? In my opinion, not necessarily.
Components of Annuity Income
Certainly, higher interest rates will lead to higher annuity income. The more the insurance company can earn on the premium, the more they can afford to pay out. But that doesn't mean immediate annuities and deferred-income annuities are not worth buying just because interest rates are low.
First, we must ask, “low” relative to what? If the alternative is 0.5% CD rates, 1.75% 10-year Treasuries or 2% high-grade municipal bonds, the cash flow from both immediate annuities and deferred-income annuities can look quite large by comparison. The real argument for income annuities in this interest rate environment is really about the structure of the annuity itself.
Current interest rates are just one of the three parts that make up immediate-annuity payments. The other two parts are the regular return of principal and mortality credits. Mortality credits are essentially the transfer of income from those that die prior to life expectancy to those that live beyond their life expectancy. In particular, mortality credits shelter immediate annuity payments from fluctuations in interest rates.
Because much of the return on immediate annuities is based on life expectancy rather than interest rates, immediate-annuity payouts don't fluctuate as much — up or down — as interest rates do. New York Life created an informational piece that shows 10-year Treasury rates fell 33% from January 2011 to December 2015. By comparison, New York Life's payout on a life and 10-year certain annuity payout for a 75-year-old male declined only 4% over the same time period.1 (A certain annuity pays for the longer of the life of the individual or 10 years).
Applying These Components in Reality
In order to take this point beyond a conceptual discussion, I ran a $100,000 quote for a New York Life 10-year certain immediate annuity for a 75-year-old male.2 The monthly payout came to $657.64, or $7,891.68 per year. To get that same amount of income from a bond paying 2% per year, we would need to invest $394,584.
Now let's be clear: The difference is not because annuities pay more interest. In fact, since the life expectancy of a 75-year-old male is roughly 11 years, one could conclude that the expected return is actually negative. Therefore, the higher payout is solely due to the other two factors — the return of principal over time and mortality credits.
Now, one might wonder why someone would buy an immediate annuity that is expected to payout less over time than the amount invested. After all, that 75-year-old male with a life expectancy of just under 11 years would have to live 12.67 years just to get his money back. First and foremost, immediate annuities are not about expected return. If they were, no one would buy them.
It's about income certainty. Remember, life expectancy is about averages. (Some people will die before that “average,” and others of course will live longer, sometimes much longer.) In fact, 50% of the males age 75 will live beyond 11 years. Do you want your clients to take the chance that they will not live beyond the average life expectancy, or do you want to assure them of an income they can't outlive?
However, if we do want to make it about expected return, then we have to go back to the mortality credits. Should that same 75-year-old male live to age 90, the internal rate of return on the annuity is about 2.25%. Should he live until 95, then the internal rate of return would be more than 4.8% ─ all because he is benefiting from the fact that the insurance company does not have to continue making payments to those who died earlier.
Lifetime Income Is the Goal
I believe all of this is beside the point. The real goal is to provide the client with the needed lifetime income with the least amount of capital possible. Let's assume this 75-year-old client has $2 million and needs an additional $40,000 per year in income. Should he attempt to fill this gap with a 2% fixed income option, he would need to utilize the entire $2 million. As an alternative, we could guarantee this same level of income by buying a $506,863 life and 10-year certain immediate annuity.
Of course, this is a bit of an apples-to-oranges comparison, because the fixed-income solution assumes that the $2 million in principal remains intact and the annuity solution does not. However, attempting to solve this income gap without the annuity greatly limits the investment options, unless the client puts the principal at risk, which in turn would put the income at risk. If, however, the client uses $506,863 of the total portfolio to cover the income gap with the annuity, he gains tremendous flexibility as to how he invests the remaining $1.493 million.
Yes, immediate annuities would provide more income if interest rates were higher, but don't let that sway you from considering annuities as part of the retirement income solution — particularly for those with a family history of living past life expectancy. Those clients might not have heard the phrase “mortality credits,” but they sure will be glad you have.
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