What Would You Think?

Imagine that you and your spouse are fifty year-olds, and in the summer of 2010 hear about the following retirement product. This annuity offers a guaranteed 8% on your money for the next 10 or more years, and then will annuitize your accumulated balance in annual payments for as long as either of you live, annually paying you 5% of the total your money was guaranteed to grow into over the deferral period. Also, as a special bonus, if you act before the promotion ends, the insurer will immediately give you an additional 10% bonus on your funds on the first day.

So, if you give the insurer $100K, you will immediately see an account balance of $110K that will grow tax-deferred over, let’s say, 15 years at the guaranteed 8% compounding into $348,939. That will then be annuitized into a lifetime annuity as long as either you or your spouse are alive of $17,447 (5% of $349K) annual payment, which will only upon pay-out be taxed based on the “type of dollars” that you had invested. (That is, if the invested dollars are from ordinary funds, a regular IRA, or a Roth IRA, your pay-outs could, respectively, be partially taxed under regular annuity tax laws, fully taxed, or all tax-free.) Sounds pretty attractive, doesn’t it?) Several insurers, such as Allianz, Aviva, ING, North American, Prudential, and many others have been doing a lot of business with this retirement annuity. Certainly after the last few years–during which the Dow Jones Index has ricocheted from 13,000 to 7,000 to 10,000, money market rates have averaged about 1%, and municipal bond rates are under 4%–this retirement annuity looks like it provides both great security and a currently seemingly cosmic guaranteed yield.

An agent, for example, might ask, “Is there any other investment today that guarantees you 8% for fifteen years?” And remind you that if you can act quickly, it is even better than that with the immediate 10% bonus. ‘And rest assured,’ the agent might continue, ‘if for any reason both you and your spouse die before having received a total of several years of annuity payments equal to your accumulated balance, then the insurer will make a final substantial payment,’ and provide details about such. The agent will also definitely mention the insurer’s A or A+ ratings and other factors to allay any possible concerns or questions about the insurer’s financial strength. “For a healthy 50-year-old couple, like you two, looking for a safe and yet attractive retirement vehicle this certainly sounds good, doesn’t it?” Sales manuals and instructors, of course, teach such language, and agents know that after asking such a trial closing question to be quiet and to wait for the consumer’s response.

The Big Question

Assuming the couple lives another 30 or 35 years, what do you think the couple’s rate of return (ROR) will be on this product? Paul, a 52-year-old, Phi Beta Kappa from an Ivy League school where he majored in economics and computer science certainly found this annuity attractive. His wife, Mary, a year younger and an economics major as well, was valedictorian of her class at their alma mater. Both have worked extensively in business, now living and working in Oregon, and currently managing a seven-figure retirement nest egg. They would not qualify as anyone’s idea of dummies.

Paul’s agent, who is very professionally-dressed, spoken, and mannered, and who was using a computer spreadsheet to present this concept, had explained that the annual rate of return is calculated by recalling that Paul’s $100K had grown into a total of $349K that was paid out, which is a gain of $249K, or in percentages a 249% increase over 35 years. Paul’s agent stated that the annual rate of return was 7.1% (249%/35 years), which he reminded again could be tax-free or otherwise depending upon the “type of dollars” with which it is funded.

Paul’s wife, Mary, who hadn’t been able to attend the meeting with their agent, also found the 7% quoted return very attractive, in fact, almost too attractive, so she calculated an average rate of return by multiplying all the quoted annual rates. She used the guaranteed annual rate of return of 8% for 15 years, included the guaranteed first year 10% bonus (if they acted promptly while it was still being offered), and the guaranteed 5% pay-out rate over 20 years. So consequently, Mary calculated the annuity was guaranteeing approximately a 6.5% annual return. It still seemed very attractive, especially since it was all guaranteed. So they called me, to ask my opinion.

When I explained that the annual rate of return over this chosen 35-year period would be 5.43%, Paul and Mary were both quite surprised. They thought they had properly understood the annuity. Paul explicitly recalled their agent’s calculation. Mary also trusted her own financial skills and arithmetic. How could this actual rate of return be so much lower than what their agent, who on his web site touts “his sophisticated mathematical and financial knowledge,” had explained, or that Mary (no dummy herself) had calculated? After all, this annuity’s returns are entirely guaranteed; this retirement product is not like a typical mutual fund or other investment where future performance is uncertain.

(Moreover, such guarantees are provided by the insurer itself, and hence are really dependent upon the insurer’s future financial performance. Life insurers’ financial performances can be and have been significantly misunderstood, as all should recall the major financial collapses of: Baldwin United, Equitable, Executive Life, General American, Mutual Benefit, etc. In contrast to bank failures and in contrast with the public’s perception of insurer failures, consumers of failed insurers have often been seriously financially harmed as regulatory actions to “protect all the policyholders” typically have involved “locking-in” policyholders to years of inadequate returns in order to preserve the myth that the policy’s purported guarantees have been preserved. )

A spreadsheet showing the correct calculation (see “Doing the Math on p. 50) it uses the financial formula for the internal rate of return on a stream of payments/investments and receipts/returns. The agent’s mistake is that it fails to take into account the compounding of money over time; it is simplistic, incorrect, and misleading. As those who know the financial “Rule of 72″ know, if a sum of money doubles over 10 years, then its average annual rate of return is not the 100% gain divided by the 10 years, it is 7.2%. Mary’s mistake arises from a little more complicated problem. Her approach fails to take into account the fact that when one annuitizes a lump-sum, as is done when the payments begin, she exchanges the lump-sum for a stream of payments guaranteed for her and/or Paul’s lifetime. Specifically, her simplistic approach of mathematically averaging the annual rates of return fails to take this fact into account; a fact properly reflected in the changing, longevity/duration dependent RORs shown on the last page. Paul’s mistake arises from his misplaced trust in their agent, an otherwise very affable guy who has the manner and trappings of professional success, yet apparently lacks the necessary competence and/or ethics.