Dear Dan,
I have a question about when it makes sense to purchase an annuity. I’m a single 67-year-old man, planning to retire in the next year. I currently have a small pension, a 401(k), other investments and savings. I’m considering putting some of my funds in an annuity. The annuity would actually pay more than my 401(k) if considering the recommended 3-3.5% annual withdrawal. I like the security of knowing I would have this guaranteed income for the rest of my life. I’m not worried about leaving money to anyone after I die. I have no children, my family and friends are all doing well financially. But when I read about annuities there seems to be few financial advisers who recommend this option. Does an annuity make sense for me?
–Ken
Dear Ken,
There’s lots to unpack here. Your situation is the type wherein an annuity can make sense but there are several reasons most people will not buy these contracts.
The type of annuity you are describing is an immediate annuity. Most annuities sold are deferred annuities which are designed to first accumulate assets before generating cash flow. Generally, within the financial planning profession deferred annuities are not well liked because they are often hampered by high costs and can create deferred taxation issues. Immediate annuities find a warmer reception conceptually. Still few people buy them even though their purpose is to guarantee income for life.
An immediate annuity could be a good choice because the most commonly cited downsides to immediate annuities are not important to you.
With an immediate annuity, you trade a lump sum for a series of payments. The maximum payment comes from a single life contract in which payments never change and stop upon your death. As of mid-June, one lower cost provider of annuities would pay a 67-year-old male $ 642 per month ($ 7,704/year) for a $ 100,000 purchase. That equates to a 7.7% payout rate.
It is important not to confuse that 7.7% payout rate with a return to your household or an interest rate earned on your $ 100,000. It is neither. Most of that payment is part of the $ 100,000 you gave the insurance company offering the annuity. If you die in a year, you will have received $ 7,704 for your $ 100,000 purchase and the insurer will pay no one else any money. That’s a negative return to your household of more than 92%. The return to your household turns positive only after the 156th payment (13 years) at which time you will be 80 and have received $ 100,152 of payments.
The longer you live the better the return to your household. Die at 90 and you will have received $ 177,192. That is equivalent to investing the $ 100,000, withdrawing $ 642 every month for those 23 years and earning a roughly 5.6% annual return. Live to 100, and the annual return is about 6.9%.
While 7.7% is a lot more than the 3.5% rate suggested by your 401(k) provider, those rates represent two very different things. The 3.5% is likely a very conservative suggestion based on safe withdrawal rate research about how much can be pulled from a portfolio to start retirement, increase payments every year for actual inflation and have a zero probability that the money would run out in 30 years.
By contrast, the 7.7% annuity payout does not adjust for inflation and guarantees that at your death, there would be no money available. If you purchase a contract that does offer an annual payment increase of some sort, a guarantee that payments will continue beyond your lifetime, or otherwise offers funds to your beneficiaries after your death, the payout decreases.
Most people would prefer not to spend all their money in their lifetimes and would rather leave money to family, friends or charity. Further, an immediate annuity purchase is an irrevocable decision, and most people are hesitant to make irrevocable decisions.
Immediate annuity purchases make the most sense for people that can’t handle volatility of financial markets, have other assets to tap if they need cash, have no desire to leave a bequest, and are comfortable with making an irrevocable decision. I can’t give you a definitive endorsement, but your situation as described is one that would make an annuity more palatable, assuming you are in good health.
Many people who are not confident they will live long past their life expectancy will not buy an annuity even if they have no heirs. Instead, they usually just invest the funds conservatively and plan on leaving the remaining funds to a cause meaningful to them. Immediate annuities guarantee cash flow for as long as one lives. That guarantee has intangible value that can be difficult to fit in the equation but it is valuable. Like most guarantees, it comes with trade-offs.
If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line.
Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.