Why You Can’t Match An Annuity’s Guaranteed Income Payout Investing On Your Own
Recent research by retirement income expert and former U.S. Treasury Department official Mark Warshawsky shows that immediate annuities generally provide you with more lifetime income than you could get by following the 4% rule or similar strategy of systematic withdrawals. One reason: Annuities have a unique and valuable advantage investors simply can’t duplicate on their own.
There are plenty of valid reasons not to buy an immediate annuity. You may not need more guaranteed income than Social Security alone will provide. Or maybe you’re just not comfortable with losing access to your money after investing it. But if you’ve rejected an immediate annuity because you think you can generate the same level of guaranteed lifetime income investing on your own, I have two little words for you: mortality credits.
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What in the world, you may ask, are mortality credits? Well, basically they’re little supplements, so to speak, that insurers factor into an immediate annuity’s monthly payout to reflect the fact that some annuity owners will die sooner than others. The idea is that the monthly payments that would have gone to the annuity owners who die early are effectively being transferred to the annuity owners who live a long life. Which means that the annuity payment you receive includes not just investment gains and the return of your original investment, but mortality credits as well. You can think of them as an extra source of return that you can’t get from any other investment.
So in practical terms how do mortality credits as well as an annuity’s guarantee of a steady lifetime payment translate into an edge over simply investing your money and carefully drawing it down? Here’s an example.
Let’s say you’re a 65-old-man and you have $100,000 you would like to convert to reliable income that will sustain you for the rest of your life. You could invest that hundred grand in an immediate annuity, and at today’s payout rates you would receive about $565 a month as long as you live. To see how that payment might vary based on the amount invested, age, sex and for both singles and couples (where income continues as long as either person is alive), you can check out this immediate annuity payment calculator.
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Or instead of buying the annuity you could invest your $100,000 and draw a monthly payment from it. Question is, though, can you get the same monthly income (or more) than the annuity provides by investing on your own? Since you want to be sure you can rely on this income the rest of your life, you’re going to have to stick to low-risk investments. Otherwise, you could hit a rough patch where returns dip precipitously and your money runs out.
So let’s say you invest your hundred grand in something relatively stable like 10-year Treasury bonds, which recently yielded about 2.2%. Assuming you withdraw $565 each month—the same amount the immediate annuity guarantees for life—your $100,000 would last just under 18 years. Which means you would run through your stash at about age 83. That may be fine if you think you won’t live beyond 83. But the chances are pretty good that you will. The Society of Actuaries estimates that a 65-year-old man has a life expectancy of 86 to 87. And since many, many people live well beyond their life expectancy, there’s a very good chance you could run through your $100,000 while you still have years to live.
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Of course, your $100,000 would last longer if you earn a higher return. At 4% a year, the $565-a-month payments would last four more years until age 87, and at a 6% return they would last until age 98. But the problem—aside from the fact that lofty returns are harder to come by these days—is that higher returns come with more volatility, which increases the risk that, far from lasting longer, your dough could run out sooner than you expect. To see how long a given sum might last invested in varying mixes of stocks and bonds, check out the retirement income calculator in RDR’s Retirement Toolbox.
So does the example above mean that every retiree should own an immediate annuity? Not at all. If you have good reason to believe you’ll die before you reach life expectancy, an annuity isn’t a good choice as you’ll be the one providing mortality credits to those annuity owners who go own to live long lives. And if Social Security’s payments are already covering all or most of your basic living expenses, you may already have all the guaranteed income you need.
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Even if you think an immediate annuity is right for you, you would want to invest only a portion of your savings in one, leaving the rest in a mix of stocks, bonds and cash that can provide liquidity for emergencies as well as long-term growth to maintain your purchasing power in the face of inflation. And if you do decide to purchase an annuity, you’ll want to shop around (payouts can easily from insurer to insurer by 8% to 10% to 10%) and take other steps to assure that you can rely on those payments coming in the rest of your life, including sticking to annuities of highly-rated insurers and keeping the amount you invest with any single insurer below the coverage limit of your state’s life and health insurance guaranty association.
Finally, you may also want to buy in stages over a few years instead of putting your money in all at once. All else equal, annuity payments are smaller when interest rates are low as is the case today (which no doubt accounts for the fact that immediate annuity sales have been declining lately, falling almost 20% the first half of this year). But if you buy in gradually, you’ll reduce the chance of investing all your money when rates are at a trough.
The upshot, though, is that unless you’re willing to take on more investing risk—which also means accepting the possibility of running through your money while you’re still alive—it’s very unlikely that you can match an immediate annuity’s guarantee of lifetime payments, which includes that extra bit of income that mortality credits provide. Or to put it another way, if you decide an immediate annuity isn’t the right choice for you, that’s fine. Just don’t fool yourself into thinking it’s because you can match or exceed what an annuity offers by investing on your own. (8/19/15)
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at email@example.com. You can tweet Walter at @RealDealRetire.