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.