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  • How Annuities Can Shine in Risky Markets

    September 12, 2011 by Phil Moeller

    September 9, 2011

    In booming markets in which all investments seem to  move upward, fixed annuities fall by the wayside. Fixed annuities  promise modest returns and may have costly fees. The products offer  guaranteed returns of principal, and thus function in part as a life  insurance policy. But such guarantees can be cheaply secured with  low-cost term life insurance, freeing up investment funds that can be  placed in more attractive holdings.

    [See 10 Steps to Fine-Tune Your Retirement Plan.]

    Today,  of course, investment markets are limping, not booming. They also are  prone to large swings. Interest rates are so low that other safe,  yield-based investments are unappealing. Low rates also reduce the  promises that insurance companies can make on annuity returns. Even so,  sales of these “plain vanilla” annuities have been rising.

    Second-quarter  sales of fixed annuities rose nearly 8 percent from the first quarter,  to $20.4 billion from $18.9 billion, according to Beacon Research. Low  interest rates did depress some types of fixed annuities. But sales of  indexed annuities, whose returns are keyed to well-known investment  indexes, more than made up the difference. They jumped 30 percent during  the quarter and accounted for 40 percent of all fixed annuity sales.

    Moshe  Milevsky is a finance professor and annuity expert at York University  in Toronto. He has long extolled the virtues of annuities and, in a recent article for Research Magazine, provides a clear framework for how to compare annuities with other investment choices.

    Milevsky  uses the example of a 65-year-old person who wants to retire now. After  accounting for income from Social Security and private pensions, the  person figures he or she needs an additional $1,000 a month, or $12,000 a  year, to retire. This income also needs to increase each year to  reflect the impact of inflation. The amount of money that’s needed to  produce $1,000 a month in inflation-adjusted dollars is, in Milevsky’s  view, the real cost of retirement.

    [See How to Use Annuities for Retirement Income.]

    One  big question, of course, is how much longer our hypothetical  65-year-old is going to live. There may be estate considerations on top  of longevity issues but for the purposes of this comparison, only the  monthly income until death is considered. Milevsky looks at three  longevity outcomes—average life expectancy for a 65-year-old (84.2  years), the 25 percent chance that the person would live to 90.1 years  of age, and the 5 percent chance that the person would live to the age  of 97.1 years.

    A second big question is how  much money the person’s investments would earn each year. Milevsky looks  at four sets of annual, post-inflation returns: zero percent, 1.5  percent, 4 percent, and 6.5 percent.

    He then  calculates the size of the nest egg needed to generate monthly income of  $1,000, adjusted for inflation, and compares this with the current cost  of buying a lifetime annuity that produces that $1,000 by guaranteeing a  post-inflation return of 1.5 percent a year. Because of low interest  rates, this is the best deal currently available on such an annuity, he  says. “We all might believe this is artificially low,” he says, “but it  is the best you can get if you want something that is guaranteed.”

    This  annuity guarantee is not offered by other investments, which is a big  selling point of annuities. Annuity guarantees are not backed by the  government but by the individual insurance company that issues the  annuity. There are state-funded insurance plans to backstop annuity  guarantees, but insurance companies have posted an excellent record of  paying their annuity obligations.

    [See When to Convert Your Savings Into an Annuity.]

    The  other selling point of the annuity is that you get the payments as long  as you live; there is no mortality risk. (If you want to insure against  dying early, you can get an annuity that will pay income to a surviving  spouse or for a minimum number of years. You will need to pay for that  certainty in the form of a higher payment for your guaranteed $1,000 in  monthly income.)

    Using these variables,  Milevsky is able to produce a table showing how much money needs to be  set aside to achieve each scenario:

     

    Cost at Age 65 to Produce $1,000 in Monthly Income for Life
    Annual Return After Inflation
    Planning Time Frame Age 0.0% 1.5% 4.0% 6.5%
    Live to Average Life Expectancy 84.2 $230,490 $200,300 $160,900 $131,600
    25% Chance of Living to 90.1 $301,700 $251,300 $190,300 $148,600
    5% Chance of Living to 97.1 $385,100 $305,600 $216,900 $161,700
    Lifetime Income via Fixed Annuity N.A. N.A. $230,000 N.A. N.A.
    Source: Moshe Milevsky

     

    The  table, he notes, “is a basic application of the time value of money,  given today’s interest rates.” People will look at the low-return,  larger nest-egg set-asides and wonder if this is the best they can do,  he says. They will look at the higher-return scenarios that require  smaller nest eggs and be drawn to them. The difference, he stresses, is  that the higher return projections also carry higher risks. If you want  to bet on higher returns, go ahead, but keep in mind that you are  betting. And the bet is much riskier at the age of 65 than 35.

    “If  you are going to assume a higher expected investment return—like 6.5  percent—compared to what is available with no risk, then you must also  allow for the possibility that things will not work out and you might  earn much less than expected,” Milevsky says. “Average the two  scenarios—and account for this risk properly—and you are left exactly  where you started, namely the present value of your $1,000 under a  risk-free return is $230,000 if you plan to life expectancy and $385,000  if you plan to the 95th percentile.”

    “If you  don’t like how big this number looks—and you want certainty—then save  more, retire later and plan to spend less,” he advises. “Assuming or  expecting or anticipating 6.5 percent or planning to age 90 only won’t  solve a structural funding problem.”

    Milevsky  goes further in his support for annuities. “The annuity price is  actually a market signal of what retirement really costs,” he says.  “And, it is the cheapest and safest way to convert a nest egg into a  lifetime of secure income. Market prices convey information and the cost  of a life annuity is a “hard drive’ full of intelligence.”

    Twitter: @PhilMoeller

    Originally Posted at U.S. News & World Report on September 9, 2011 by Phil Moeller.

    Categories: Positive Media
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