This article was first posted on August 1, 1999.
The release of William F. Sharpe's Financial Engines Retirement Planner prompted some interesting questions on buying an annuity when you retire. The Financial Engines software estimates your retirement income with the assumption that you liquidate your portfolio and buy an immediate life annuity on the day you retire. (Note: To Financial Engines' credit, they say they are not recommending that you buy an annuity. They are merely using an immediate life annuity as a mechanism to forecast retirement income.)The purchase of an annuity forecloses a retiree's participation in the stock market and will likely reduce his returns in the long run.
You can find quotes on both immediate life annuities and period certain annuites (as well as several permutations in between) at the AnnuityShopper web site. Competitive quotes for immediate life annuities and period certain annulites are shown in the tables below. Table One also includes data from the IRS Life Expectancy Tables for comparison.
A quick comparison of Table 1 and Table 2 reveals some interesting anomolies. The single immediate life annuity for a 65-year-old yields an annual benefit of 8.964% of the initial premium and the IRS life expectancy table lists 20 years to live. Yet, a 20 year period certain immediate annuity has a benefit of only 7.884% annually. It appears that the insurance company is betting our 65-year-old will live less than 20 years, otherwise the 20 year period certain benefit would equal the annual benefit for the life annuity.
What about inflation?
While an immediate life annuity ensures you will never outlive your nestegg, it doesn't protect you against the ravages of inflation. So the generous annual benefit that some people find so attractive must be adjusted for future inflation. One way to do this is to hold back part of the annual annuity benefit payment and place it in a sinking fund. The sinking fund is then invested in the hope that it will grow and supplement the annual annuity benefit in the later years. Someone drawing $50,000/year today would need $132,000/year in 20 years if inflation averaged 5% per year.
For example, let's say a 65-year-old male buys an annuity. Table One shows a 8.964% annual benefit and the IRS Life expectancy table says our 65 year old should live on average another 20 years. To give our annuity buyer every benefit of the doubt, let's say he lives for 40 years, to age 105. Surely if you live to 105 an annuity is a good deal.
To adjust for inflation we need to make two assumptions, what's the inflation rate, and what kind of return do we expect on our sinking fund. If we decide to be "95% safe," the inflation rate for a 40 year pay out period is 4.46%. That means for 5% of the 40 year pay out periods examined, inflation was higher than 4.46%. Similarly, the "95% safe" investment return on the S&P500 for a 40 year pay out period was 6.1%. Again, that means that in 5% of the 40 year pay out periods examined, the S&P500 index returned an average of less than 6.1%. So we are being conservative in making these assumptions.
Retire Early has developed another in our series of "Shaft Detector" spreadsheets -- the Retire Early Annuity Shaft Detector. You can download a copy free.
(11k zip file (annusft.zip), expands to Microsoft Excel Workbook file (annusft.xls), 33k)
Remember, you need pknuzip.exe to expand the zip file and return it to Excel format.
Using the Annuity Shaft Detector spreadsheet, the 8.964% annual annuity benefit was reduced to an inflation-adjusted 4.71% the first year. The "95% safe" withdrawal rate from a portfolio of stocks and fixed income securities invested at the "efficient frontier for a 40 year pay out period is 4.44%. So an annuity only increases your withdrawal by 0.27%, while eliminating the substantial upside of remaining invested in equities. One look at terminal portfolio values that accompany safe withdrawal rates (see Table 4., below) should dissuade you from shortchanging your hiers or a bequest to a charity with the purchase of an immediate life annuity. There's a 50/50 chance your hiers would get at least $5 million and a 90% chance they'll inherit at least $1 million. Of course, with an immediate life annuity, your hiers get nothing.
filename = buyannu.html
Copyright © 1999 John P. Greaney, All rights reserved.