Stocks vs. immediate annuity

On 2009-04-07 13:00:00 -0700, Igor Chudov said:This is true regardless of stock price fluctuations, large or small,

Good points. We have seen many banks fail when hardly anybody believed it could happen, and we have seen AIG and Merril Lynch fail. So I certainly would not want to take it for granted that insurance companies, or any particular insurance company, will be in business forever, or even for the next 15 years.

And I doubt if we can assume that the circumstances which would lead to failure of insurance companies would necessarily be more extreme than anything happening at present. We have no knowledge of the chicanery and greed at work in that sector any more than we knew about what bankers, Madoff, etc. were up to in their secret dealings.

That's a very low return, according to

When you die, what happens to the "principal" of $243,000?

This depends on the contract, life only vs. not life only.

My example was "life contingent", which means, if I understand it correctly -- which I may not -- that payment shoud stop when I die and no principal is returned.

But maybe I am awfully off base.

First of all, due to careless typing, I made a typo, it should have been 253,000 instead of 243,000. I am a male who is 38 years old.

Correcting for this, and entering the minimum age of 40 that the above site has, I get monthly payment estimate of $1,310. A comparable quote from the website that I visited (brkdirect), for 40 years old, would be $1,020.

However, brkdirect has an AAA rating, and for those who no longr believe ratings, it is in any case well capitalized. The above website has quotes from insurance companies who I do not know.

I am not really an expert in this. But for a potentially 50 year long contract, I would like to do it with a fnancially strong insurer.

I'd not take this bet. I can't accurately guess the long term rate of return from here, but it's likely to be higher than what you are looking at. Look at DVY, yielding over 5%. I think much of the negativity is built in to the price/yield. But say it goes down by half. 2.5%. Earnings growth below historical norms will push that beyond 4% again in a reasonable amount of time. And that will push the price up. eventually, you'll be earning far more than 10%/yr on your original investment. 50 years of inflation will kill you with the annuity. At 3%, it's about 1/4 the current value, i.e $1000 will be worth $250. Time is on your side. If you were 65, this conversation would be different.

Joe

For a 40 yr old male in my state, it's a touch over 6%.

These are generally not intended for folks that young - it's meant as a guaranteed income stream for as long as you live. Dividends may get cut at the discretion of the companies. S&P is having trouble maintaining their "dividend aristocrats" list - the list of companies which have increased dividend payouts for 25 yrs or more - see:

It's going to fall below 40 companies. And even that gold-standard subindex of the S&P500 lost almost 50% in this market. And the dividend payout on that index can fall - as stocks fall out of it.

Earnings for the S&P500 have fallen a lot.

If this is the money you need to live on - to pay your most essential bills - dividends on stocks are not the way to do it. Immediate annuities are exactly meant for that - cover the *essential* cashflow. Go ahead and invest the rest in dividend stocks - let those divs be your discretionary spending. But groceries and health care and property taxes and mortgages - those bills *must* be paid and for that, for retired folks, immediate annuities are something to think about.

For an under-40 person still working and saving? Probably not appropriate. For a portion of the portfolio of a retired 65 yr old? Certainly reasonable. And you'll note that the payout yield for that 65 yr old is more like 8 to 8.5%.

Joe, this was a hypothetical exercise, as I do not think that an annuity is even close to being suitable for me at my current place in life.

I agree that, pretty much however sliced, any stock index at this point that pays dividends, DVY or SPY, is clearly at enormous advantage over similar annuities. (bankruptcy protection aside). The advantage is so large that it would be unlikely to continue for too long. This is a totally different game than it was 1.5 years ago.

Igor Chudov wrote: snipped-for-privacy@gmail.com

No, I think you are correct. I was asking to see if you were aware of what an annuity (very generally speaking; see below) really meant. In which case, short of living a really long time, the return is going to be negative. To me, what one gets with an annuity is simply some peace of mind via an alleged (as you note) guaranteed income for life. The price of this is giving up the principal. I mean, to those of us who feel comfortable managing our own portfolios, living within our means, and so on: Give up the principal? Oh m'goodness no.

Granted there are many different types of annuities; my post should be taken as a general be-aware-this-is-often-the-bottom-line, and it is a shocker.

Here's an interesting article from today's WSJ about bailing out life insurance companies who made overly generous promises (that is, managers underreserved and overbonused themselves).

I am only posting a small portion of this article to avoid copyright concerns.

The department is expected to announce the expansion of the Troubled Asset Relief Program to aid the ailing industry within the next several days, these people said. [insurers' shares]

The news will come as a relief to a number of iconic American companies that have suffered big losses made worse by generous promises to buyers of some investment products. Shares of life insurers have fallen more than 40% this year. Their troubles led to a string of rating-agency downgrades that, in a vicious cycle, made it more difficult for some insurers to raise funds. ...

Thanks for posting this because it helped me clarify some thoughts on the subject, posted here for discussion.

An immediate annuity is only loosely comparable to a stock portfolio, they are really two different things. One reason that immediate annuities are sold by insurance companies is that they are insurance, just like fire insurance.

With fire insurance, you are paying the insurance company to assume the risk that your house will catch fire. And you pay an insurance premium for that. For an immediate annuity, you pay the insurance company to assume market risk and the risk that you will out live your money. You can even pay them to assume inflation risk. And you pay an insurance premium for that. It is not explicit, but is in the difference in returns that you noticed.

I can't think of an reason that immediate annuity would be useful for someone in the accumulation phase of life, although I'm sure the smart people here will tell me if there is one.

On the other hand, an immediate annuity can be really useful for older folks. Surveys show most retired folks are at least somewhat worried about out living their money. An immediate annuity can help with that. Current market volatility is gut wrenching, especially if it starts to impact groceries and rent. An immediate annuity can help.

An immediate annuity can simplify finances. You don't have to manage investments, you just cash the check every month. As mental state fades, this can be really important.

You also get a much better monthly return than many alternatives when you are older. True, part of it is a return of capital based on your life expectancy, but you are getting it and will as long as you live.

One advantage is some degree of fraud protection. Late in life, my mom was starting to get all sorts of suspicious calls. She had the mental state to know they were suspicious, but not everyone does. With an immediate annuity, there is no lump sum that can be conned out of an older person. At worst, the con artist can only get part of the income stream and then only until someone catches on.

Oh, I know that there are other ways to limit you exposure to market volatility, I'm using them. Just noting that immediate annuities do that, too.

-- Doug

Unless I am mistaken, the amount of income that you receive monthly for the rest of your life can vary widely, depending on the current interest rates on bank deposits, etc. at the time you purchase the annuity. Also, there is some lag in time before the annuity rates catch up with changes in the bank rates. In other words, if you buy an immediate annuity when interest rates are low, like today, you will be stuck with a low monthly check for the rest of your life, no matter how much higher rates may go in the future. My information here may be outdated, but that is how it used to be. I certainly would want to explore these matters more thoroughy before purchasing an immediate annuity.

At any rate, when making these comparisons, do not assume that what annuities cost today will be same at all times in the future. You are certainly paying the insurance company to assume a risk, but I guess an important question is HOW MUCH are you paying for that service when compared to other possible ways of getting a return on your money, not only today but throughout the rest of your life.

Does monthly or annual "return" mean anything when you sign away the principal in the first place?

Sure, if you like to call them insurance, that's fine.

With an immediate annuity, giving me a yearly payment of X, there are two risks:

If I invest a comparable amount of money in stocks, and get X in dividends, then my only risk is that dividends will be reduced in the future, in real terms. However, the potential rewards of owning stocks, even without ever selling them, is that dividends will modestly rise in the future. Such a reward is absent in an annuity.

I agree.

It is true that for older people, annuity payments would be higher than in my example of a 38 year old investor.

Very well put.

Just curious, what sorts of calls was she getting. I have parents too and would like to know more.

Igor Chudov wrote: However, the potential rewards of owning

A diversified portfolio of dividend paying stocks can easilly see annual increases higher than inflation. Just saying: I do not call exceeding inflation "modest."

You can buy inflation adjusted immediate annuities. Of course, the yearly income stream (is that better than "return"?).

It is my understanding that insurance companies are backed by state insurance funds, similar to FDIC. Can someone confirm that?

Or in absolute terms. Or some of the companies will go bankrupt, wiping out both the dividend and capital. I my mind, we are not talking about comparable levels of risk. Perhaps a better comparison would be a bond/CD ladder.

"Might", even "probably", certainly not "will", rise modestly in the future.

There is no way I think an immediate annuity is the only answer to retiree finances. Stocks have to be part of it. But annuities have some advantages, especially for older folks. That same site you mentioned shows a 75 y/o male can get $1,000 a month for life with an investment of $120,337. That's a 10% "return".

Getting that kind of income out of stocks and bonds pretty much requires you to invade principle. That raises the question of how long you are going to live. Remember "life expectancy" means half the people are going to live longer and half are going to die sooner. Unless you are in very ill health, you need to hedge against you being in the long-lived half.

Interestingly, the insurance company doesn't need to make this hedge. Because they write lots of annuities, they can pretty well count on enough people dying on time to make up for those that are so rude as to live longer.

The one I remember is a call from someone who claimed to be from AT&T Financial Services asking about her finances. Best as I can tell, there is no such thing in AT&T. One that has been on the news around here is someone calling claiming to be a grandchild in trouble (jail, stranded, etc) and asking for money.

-- Doug

Dying is the third risk. Some immediate annuity provide no guaranteed number of payments, so if you die the year after your purchase, your heirs are out that money. Joe

Yes, it does. And you can ditch your scare quotes around "return".

You're trading a lump sum of money for a series of cash flows. That's no different than any other investment and you can compute the annual (or monthly) return exactly the same way -- find the discount rate that sets the NPV of the series (including the initial investment and any payout at the end) equal to zero.

-- Rich Carreiro snipped-for-privacy@rlcarr.com

A life expectancy is assumed, of course. With that assumption, the quotation marks stay. (And Richard, no need to get testy. Take things post by post and the dialogue here will be much cleaner insofar as getting the facts out.)