The reader, age 65, faced a dilemma. His adviser at Fidelity had suggested he commit all of his fixed-income assets — about half of his $1.9 million in financial assets — into a life annuity. The annuity would pay about 5.7 percent on his premium. If he died before his entire premium had been paid out, the remainder would go to his estate.
The reader, however, thought things were fine as they were. He covered his expenses by taking only 3 percent from his investments.
But he doubted himself.
Always consider alternatives
Here’s my explanation of his situation and two better alternatives:
While basic life annuities (not the complicated fixed-index kind) can be a good substitute for a pension for many people, the suggestion you’ve received doesn’t fit your situation. You’ve got plenty of assets. Equally important, those assets produce sufficient income to pay all your bills.
So why give up your principal — and a lot of flexibility — to get a monthly check? It doesn’t make sense.
Avoid extreme suggestions
The sales rep’s suggestion is also pretty extreme — sell all your fixed-income assets and exchange them for a life annuity. You’d have income, but that’s all you’d have. Your ability to respond to emergencies would be massively reduced. That’s less security, not more.
Your sales rep was only half honest when he told you there was no cost. While the life annuity involves no direct commission or annual charge, the reality is that he is going to be paid a commission of some sort. The payment won’t be coming from the Tooth Fairy. Odds are, this sale is the single largest personal income opportunity he has with your money.
What insurance companies do
Insurance companies, like banks, are intermediaries. They take in your money, make some kind of promise of payment to you (interest, lifetime payments), and then they invest the money. They hope to earn more than they will need to pay out to you.
So they’ll pay the sales rep and slowly pay you back with your own money.
I’m pretty sure they’ll do quite well.
How can I be confident?
The insurance company will do well
Simple. They’ll dribble your money back to you over your lifetime. It will take, by your calculation, 17.5 years before you get it back. If you die before then, your estate will receive the remainder of your original deposit. This means that if you die anytime before 17.5 years, the insurance company will have had use of your money without paying a dime in interest for the entire period. Free money!
They have a cost for your deposit only if you live longer than 17.5 years.
According to the most recent CDC Life Tables, the life expectancy of a 65-year-old male is now 18.1 years. So while some annuity holders will live longer than 17.5 years, odds are that the insurance company has the use of your money (and that of many other 65-year-old men) for next to nothing.
So it’s a great deal for the insurance company and a nice commission for the sales rep, even if it doesn’t do much for you. I’m sure they feel that two out of three ain’t bad.
Some people really need that assurance of a relatively high monthly cash payment coming in the mail. I don’t think you’re one of them.
The best life annuity deal comes from Social Security
There are two good alternative uses for some of that money.
The first is to effectively “buy” an inflation-adjusted life annuity. You can do this by delaying your Social Security benefits. Instead of taking them at 66, take them at 67, 68, 69 or 70. Since your benefit will increase by 8 percent for a year of delay, you’ll get your money back, in real purchasing power, in about 12.5 years. That’s way better than any offer you’d receive from an insurance company. (Note: The actual rate of increase for delaying Social Security benefits is slightly less than 8 percent per year before full retirement age.)
Delay five years to age 70 and your monthly Social Security benefit will increase by nearly 40 percent. Basically, you’ll get a lot more bang for your buck.
The odds are in your favor with investing, too
A second alternative is to continue investing pretty much as you are now and take a chance that you will outlive your money. As it turns out, that isn’t much of a risk. You can test this out for yourself by visiting one of my favorite websites, Portfolio Visualizer . It allows you to do Monte Carlo runs for portfolios of different types, with different assumptions about how much is distributed each year.
If you invest in a basic Couch Potato portfolio — 50 percent Total U.S. stock market and 50 percent Total U.S. bond market — and withdraw a fixed amount annually that is equal to the 5.71 percent payout in the life annuity offer, there is a 99.79 percent chance that your money will last 18 years and a 97.54 percent chance that it will last for 30 years. Even if the return on that portfolio is in the bottom 10 percent of all probable returns, it will still have a balance equal to 98.6 percent of your original investment after 30 years.
As a practical matter, you don’t need that much of a payout since you’re now paying your bills with a 3 percent withdrawal rate. So let’s see what happens if you start at 4 percent and adjust the original dollar amount upward each year for inflation. Answer: 90 percent of the time you’ll enjoy an inflation-adjusted increase in income for the entire period and have at least 115 percent of your original investment at the end of 30 years, when you are 95. At that age you have a 95 percent chance of being dead.
Is there a chance, any chance, that you’ll run out of money? Yes. The simulation suggests that there is a 1.77 percent chance of running out of money in 30 years. That, however, is tiny compared to the 95 percent probability of being dead.
Sources and References:
The Portfoliovisualizer website: www.portfoliovisualizer.com
United States Life Tables, 2016, National vital Statistics Reports, 5/7/2019 https://www.cdc.gov/nchs/products/life_tables.htm
Michaer Kitces, life expectancy and mortality calculator: https://www.kitces.com/joint-life-expectancy-and-mortality-calculator/
This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
Photo: Scott Burns
(c) Scott Burns, 2019