A lot of companies and websites advertise immediate annuities and post enticingly high “payout rates.” For example, as of this writing I am seeing advertised on the Internet immediate annuity payout rates as high as 20%. Who wouldn’t be attracted to this when 1-year certificates of deposit (CDs) are paying currently 1% or less? Well, you shouldn’t be! Beware, payout rates are misleading and should be ignored when considering immediate annuities. Pay attention instead to how much monthly or annual income you will receive, and what the timeframe guarantee is. Let’s explore why.
Example – Period Certain Immediate Annuity
First, let’s look at what is the payout rate and how it’s different than the interest rate that most of us commonly think of with a period certain annuity (this is an annuity that guarantees fixed payments for a fixed period of time). I am looking at a 5-year period certain immediate annuity on the Internet now. It says that for a 65-year old man investing $100,000, he (or his beneficiaries) will receive $1,680 per month for 5 years. It also says that the payout rate is 20%. Sounds great! No, it isn’t! Here’s why. $1,680 per month = $20,160 per year. The annual payout rate is the amount paid per year divided by the initial investment, or $20,160 / $100,000 = 20.16%. But wait, what does this really mean? Nothing! Just a useless calculation designed to confuse investors. Because what we commonly think of as an interest rate, or rate of return, is in this case 0.3% per year! (This is using the time value of money equation). In comparison, at the time of this writing a 5-year CD has a rate of return of about 2% per year. If you are being presented with a period certain annuity, ignore the payout rate and calculate, or ask your advisor or agent to calculate for you, the rate of return. This way you can compare it easily to other investments like CDs and fixed annuities. Apples to apples, not apples to oranges!
Example – Lifetime Immediate Annuity
Let’s look at another example with a lifetime immediate annuity – an annuity that guarantees you a set monthly or annual payment for as long as you live. As of this writing, a 65-year old man investing $100,000 into a lifetime immediate annuity that guarantees 5 years to beneficiaries will pay about $7,000 per year for as long as this man lives. So, you will see a payout rate advertised of $7,000 / $100,000 = 7%. What does this mean? Nothing! Again, it is just designed to confuse you into thinking this is a 7% interest rate, which it is not. What’s the real rate of return? Well, that depends how long he lives. We know that at a minimum, if he dies anytime during the first 5 years, he will receive $7,000 x 5 years = $35,000. So he will have received a highly negative rate of return on his $100,000 investment. That’s a big difference — 7% payout rate vs. a negative rate of return. On the other hand, if he lives to be 90, he will have received $7,000 x 25 years = $175,000. This computes to an interest rate, or rate of return, of 4.87%.
Don’t Let Payout Rates Confuse You –
Focus Instead on the Three Ways Immediate Annuities Can Protect You
Our simple advice – ignore the payout rate when considering an immediate annuity. It is only designed to confuse you. Pay attention instead to how much monthly or annual income you will receive, and what the timeframe guarantee is. Remember, an annuity can protect us against essentially three important risks: longevity risk — the risk of living longer than our life expectancy; market risk — the risk that our income will fall if stock prices or interest rates go down; and what we might call judgment risk — which is the risk that we, ourselves, might do something stupid to harm the lifetime income stream on which we depend.
Annuities makes sense if your risk profile is that you would rather have a higher consistent pay out and put the risk of living longer than your life expectancy on the insurance company. One of our clients shared with us his viewpoint, which we thought was instructive: “If all I really want from my million dollars is $80,000 a year for the rest of my life, then do I really care if I get my $80,000 a year for three years and then die? True, it’s a net gain for the insurance company, but was it really a loss for me personally? I’m dead, so it isn’t like I’m going to miss the money. And I could choose an option to return the remainder to my heirs. Alternately, I could try and manage the money myself, which requires a lot of time, education, and energy, but without guaranteed lifetime income, I’m in a much worse position than I would have been with the annuity.”