Posts filed under 'Annuities'
Who Should Buy an Annuity?
by J. David Lewis, NAPFA-Registered Financial Advisor
In the last couple of months, we have spent quite a few hours helping an elderly lady obtain cash from an annuity, when she and her attorney were unable to locate the salesman who received a commission for selling it to her as an investment. My belief is that annuities are not bad things, when understood and used for the purposes they are intended. The problem is that they are often sold for reasons that have little or nothing to do with an indefinite stream of income, which the word “annuity” implies.
The concept is simple. To insure a specific cash flow for the remainder of your life, no matter how long you live, an annuity is the solution. You give an insurance company an amount of money and they guarantee a stream of income. When you die, if they have not repaid all you gave them, plus whatever it earned in their portfolio, they keep the remainder to pay those who live a longer time and support their profits. If you die in a short time, your heirs could lose a lot. If you live a long time, you can come out much better. The certainty of being sure of “cash flow for life” is an attractive option when the decision is made clearly.
A few of our clients have 403(b) retirement plans that require their participants to buy annuities with a significant portion of their accumulated accounts at retirement time. Those sponsors appear to be attempting to protect their retiring employees from mistakes with their nest eggs. It is a reasonable requirement.
Social Security is a form of annuity. We all pay in for most of our lives. Social Security pays monthly income for the rest of our lives. Social Security income stops at death, except for the smaller part spouses can receive until their death.
To reduce the risk of heirs losing money, insurance companies offer optional terms that continue to pay heirs for a specified number of years, even if the buyer dies very early. Although this choice reduces the monthly income, it should generally mean someone receives at least some return on the “investment.”
Here is an example. A husband, age 62, and wife, age 54, have $500,000 that could be used to buy an annuity stream of income for as long as either lives. They have many options for investing this money. For comparison, we used Vanguard’s website to test various annuity ideas. Vanguard has a reputation for low cost investment options. We stipulated that the monthly payments will continue for twenty years, even if they both die earlier, and that the survivor will continue receiving the full monthly payments as long as they live. For the $500,000, Vanguard’s annuity will pay $2,223.88 per month for twenty years, plus as long as either of this couple is living.
If both die within the first 20 years, the insurance company will pay $533,731.20, which is the total of 240 payments at $2,223.88. If we think of this like a mortgage, the $33,731.20 additional in payments is interest through the years. It calculates to an annualized return of 0.67% on the $500,000. Of course, if either lives longer than twenty years, the return gets better. Once the $500,000 has been received, the rest is return on investment. Here is a table to illustrate how the annualized return improves if one of this couple lives beyond twenty years:
| If you live: |
Your return is: |
| 25 years |
2.42%. |
| 30 years |
3.43%. |
| 35 years |
4.03%. |
| 40 years |
4.43%. |
| 45 years |
4.69%. |
| 50 years |
4.87% |
From 1926 through December 2008 the annualized return for the S&P 500 Index was 9.6%. Long term government bonds returned 5.7% over the same period. Notice that December 2008 was at a very low point in the recent bear market. A well balanced portfolio should provide returns somewhere in this range over twenty to fifty years.
If this couple loaned someone $500,000, as a well secured 30-year first mortgage on their home and the interest rate was 4.25%, the monthly payments would be greater than the annuity - $2,459.70. They would be 92 and 84 at the time of the last mortgage payment and their heirs could inherit the remaining balance, if they didn’t live that long.
So, an investor in an annuity’s stream of income essentially gives up the possibility of returns from a diversified long term portfolio. In exchange, they should get peace of mind from the certainty of that monthly cash flow. For many people, this peace of mind is well worth the potential portfolio return they forgo. In the last twelve months, we have helped at least one person we consider relatively sophisticated understand this logic. They decided to buy the annuity. So long as they can understand their potential choices, we believe an annuity can serve a role in helping them enjoy their wealth. For that client, we consider the project a success.
I have sometimes commented publicly on annuities as investments. An example is at Downside Protection Has Downsides – WSJ.com.
Contact J. David Lewis directly with david.lewis@resourceadv.com or share your thoughts on this topic below. He founded Resource Advisory Services in 1985. National Association of Personal Financial Advisors (NAPFA) was formed only a few years before. Lewis became a NAPFA-Registered Financial Advisor in 1986. He is a passionate advocate for fiduciary, fee-only financial planning and has been associated with financial services since childhood in a banking family. 48399
November 4th, 2010
Our Comment by J. David Lewis – I found this article very interesting and timely. As the excerpt below highlights, much of traditional investment discussion has focused on accumulating assets and selecting an array of instruments. Now, at least some mutual funds are developing their marketing around the idea that they are particularly well suited to reliable streams of cash flow for the investors’ lifestyle spending. For us the really interesting issue here is that we have been using and discussing prudent withdrawal rates from investment portfolios since the mid 1990s. Our methodology has characteristics that are very similar to those attributed to this “new bread” of mutual funds. While the concepts make a great deal of sense to us, we believe it is not as simple as buying a mutual fund to solve the withdrawal rate problem for any client.
By Robert D. Hershey Jr., Published: October 9, 2010
“Although consumers have been slow to embrace managed-payout funds, the group’s rationale, at least, seems solid. The funds are aimed at investors at the stage of life when the top priority is a flow of income available for spending rather than the accumulation of assets.
Payout funds offer various approaches. Some are set up to provide a specified monthly payout, while others pay variable amounts based on what the portfolio produces. Some plan to deplete principal by a certain year; others can leave assets for heirs. Unlike annuities, payout funds have no guarantees. And they differ from target-date funds in that they are intended to get an investor “through” retirement, not “to” it.
“It’s a very attractive idea,” said Dan Culloton, Morningstar associate director of fund analysis, albeit with the caveat that its execution “is still a work in progress.”
Read the rationale via Managed-Payout Funds Help Boomers Deal With Retirement – NYTimes.com.
Contact J. David Lewis directly with david.lewis@resourceadv.com or share your thoughts on this topic below. He founded Resource Advisory Services in 1985. National Association of Personal Financial Advisors (NAPFA) was formed only a few years before. Lewis became a NAPFA-Registered Financial Advisor in 1986. He is a passionate advocate for fiduciary, fee-only financial planning and has been associated with financial services since childhood in a banking family.
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October 24th, 2010
Our Comment by J. David Lewis: I heard a great story on NPR’s “Planet Money” this morning (WUOT FM 91.9 in Knoxville, TN). This one helps understand the importance of ways financial advisors are paid. The incentives have a great deal to do with the results. If you pay people to sell mutual funds, annuities or insurance policies, more mutual funds, annuities or policies are sold. If you pay people to manage growth and strength of net worth, client net worth is far more likely to improve.
”Back in the 1700s, the British government paid sea captains to take felons to Australia. At first, it didnt work so well, Tabarrok says:
‘About a third of the males on one particularly horrific voyage died. The rest arrived beaten, starved, and sick. I mean, they were hobbling off, those who were lucky enough to survive.’
This was a scandal back in England, so the government tried to fix it with all different kinds of rules. Force the captains to bring a doctor along. Require them to bring lemons to prevent scurvy. Have inspections. Raise captains’ salaries. None of it worked.”
Listen to the solution via Pop Quiz: How Do You Stop Sea Captains From Killing Their Passengers? : Planet Money : NPR. [3 min 29 sec]
J. David Lewis founded Resource Advisory Services in 1985. National Association of Personal Financial Advisors (NAPFA) was formed only a few years before. Lewis became a NAPFA-Registered Financial Advisor in 1986. He is a passionate advocate for fiduciary, fee-only financial planning and has been associated with financial services since childhood in a banking family. Contact him using david.lewis@resourceadv.com.
September 10th, 2010
Our Comment by J. David Lewis – I really like this “Intelligent Investor” column by Jason Zweig. He discusses the public’s reactions to recent market volatility. Many are seeking safety in a type of annuity product. Then he tells us pretty much what a fiduciary would tell someone asking for advice on these annuities. I posted my comment on WSJ.com soon after I read the column, because we have seen the troubling aftermath from these annuity sales. Other WSJ.com comments are almost as interesting as the column itself. A few attempt to justify annuity expenses and risks that are very difficult for typical consumers to understand. Others support Mr. Zweig’s exposure of the expenses and other issues. Potentially, the Securities and Exchange Commission will issue regulations that move all financial advisors toward a fiduciary standard that places clients’ interest first. If the regulations are strong, consumers will be better served.
Mr. Zweig says, “Money has hemorrhaged out of “U.S. stock funds for 18 weeks in a row, with an estimated $15 billion flowing out in August alone. Much of that is being soaked up by a form of insurance sold as a safer alternative to stocks.
Fixed-indexed insurance products, commonly called “equity-indexed annuities,” offer the promise of protection on the downside combined with a guaranteed minimum upside. They racked up a record $8.2 billion in new sales in the second quarter and hit an all-time high of $168 billion in total assets as of June 30, according to Limra and Beacon Research.”
Read Mr. Zweig’s column via Downside Protection Has Downsides – WSJ.com.
Our Comment on WSJ.COM - Welcome back Jason. I have missed your weekend stream of wisdom. This column is particularly well timed. Until April of this year, I was getting concerned that people were loosing some of the cautious mentality brought on by the bear market. It seems the volatility since May 31 has injected a healthy dose of memory. Of course, with that comes the tendency for people to fall pray to a sense of certainty, even if there are downsides they do not recognize. There are always risks in everything. The trick is to see them clearly and make good decisions with them in sight.
In my experience, it is not the risks we can see that give us trouble. We deal with those. The risks we don’t see are the ones that get us. And, the salesman, who is not held to a fiduciary standard of putting the client’s interest first, has great temptation to avoid giving his or her customer a clear explanation of all the risks that the customer is not able to see on their own. In deed, being paid by commissions can motivate the sales people themselves to believe there is no risk in these annuities they are selling. It is amazing what some people will believe if you pay them enough to believe a line.
J. David Lewis founded Resource Advisory Services in 1985. National Association of Personal Financial Advisors (NAPFA) was formed only a few years before. Lewis became a NAPFA-Registered Financial Advisor in 1986. He is a passionate advocate for fiduciary, fee-only financial planning and has been associated with financial services since childhood in a banking family. Contact him using david.lewis@resourceadv.com.
September 5th, 2010
This list has some key things to think about. Click here – 13 Things Your Financial Adviser Won’t Tell You – Manage Your Life on Shine.
April 29th, 2010
Safety nets fray when times get hard. Retirements that once looked secure are hanging by a thread. The message for those in their 50s is clear: Mend the nets while there’s still time. Those in their 60s and 70s have fewer options. Still, there are ways of making sure your money lasts for life. Here’s how to do it in 12 easy steps:
Yesterday, someone called us to talk about whether we can help sort out their retirement issues. An AARP Bulletin article prompted them to the research that found us. While we cannot say that every idea in the article fits in every client’s case, we can say that the article has a good collection of resources for figuring out a lot of things for yourself and/or finding the help you might need. We recommend reading it via Do-It-Yourself Financial Freedom – 12 Steps for a Safe Retirement – AARP Bulletin Today.
April 14th, 2010
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