Why We Should Love some Annuities

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Why We Should Love (some) Annuities

• Houston Investors Association / Getting Started
  SIG / 8 Mar 2008

Leigh Anderson Presentation at
www.tayara.com/hia
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What is an annuity?

• A Contract
• in return for a lump sum up front, it pays a
  guaranteed stream of income as long as you live
• Sort of like life insurance in reverse
• Life insurance bet you will die soon, transfer
  the financial risk of premature death
• Annuity bet you will live forever, transfer the
  financial risk of living too long (and going
  broke)

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Why might we need annuity in retirement?

• Investment return is uncertain can be bad for
  years
• Lifetime uncertain we may live much longer than
  expected
• Safe withdrawal rate from portfolios is about
  4/yr or less
• may not be enough to live on
• An annuity gives more income, guaranteed for as
  long as we live

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Types of annuities

• Income Annuity ( Immediate Annuity)
• Buy with lump sum up front pays steady income
  continuously until death
• Deferred Annuity
• Accumulates value (on tax-deferred basis) over
  time then converts to Income Annuity at
  retirement.
• Payment options
• Fixed Annuities pay constant amount per month
  (optionally with inflation adjustment)
• Variable Annuities pay varying amount based on
  investment returns
• Equity index Annuities (EIA) promise partial
  upside of equity returns with guarantee of no
  losses

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Cave Canem

• Just as all dogs are not the same, neither are
  annuities
• If it has to be sold, its probably not worth
  buying
• Good (you have to seek them)
• Low expense Income Annuities, either fixed or
  variable payments
• Vanguard, TIAA-CREF
• Bad (pushed by high-commissioned brokers)
• Deferred Annuities
• Equity Index Annuities

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Income (or Immediate) Annuities

• Exchange lump sum of money for a guaranteed
  income
• Usually for life of investor (and possibly
  spouse)
• Less healthy annuitants receive age rate-up
• increase income because of a shorter life
  expectancy
• Taxes
• If funded from IRA, all income is taxable
• If from after-tax funds, portion (about 60) is
  return of principal and not taxed
• Income annuities improve standard of living
• Higher income and lower risk than bond portfolio.
• Yet few people purchase income annuities.
• Most accept SS and DB (if any) and invest the
  rest.
• Many take lump sum option at retirement.

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Simplifying assumptions for examples

• Single male, retires at 65, with 100,000 lump
  sum in cash
• Life expectancy
• 50 chance reaching 82.5 (17.5 years)
• 10 chance reaching 94 (29 years)
• Interest rates (T-Bonds) 4.3
• Will compare
• Spending down a bond portfolio
• Vanguard fixed payment annuity

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Example (ignoring inflation)

• Invest 100K in bond portfolio, spend down to 0
  by age
• 82.5 678/month income
• 8.1/yr withdrawal rate 50 chance outliving
• 94 503/month income
• 6.0/yr withdrawal rate 10 chance of outliving
• Use 100K to purchase Income Annuity
• 725/month income
• 8.7/yr initial withdrawal rate 0 outliving
• Equivalent to 7.8 investment yield to age 94

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Example (payments adjusted for inflation)

• Increase income payments by 3/year for inflation
• Invest 100K in Bond portfolio, spend down to 0
• 82.5 532/month inflation-adjusted income
• 6.4/yr withdrawal rate
• 94 345/month inflation-adjusted income
• 4.0/yr withdrawal rate
• Use 100K to purchase Income Annuity with
  inflation adjustment
• 542/month inflation-adjusted income
• no risk of outliving 6.5/yr initial withdrawal
  rate
• Equivalent to 8.0 investment yield

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Example (payments based on portfolio returns)

• Variable payments depending on performance of
  investments (stock, bonds, REITs, etc)
• Assumed Investment Return (AIR) of 3.5 or 5
  (your choice)
• Payments adjusted annually depending on
  excess/shortfall of performance
• Not adjusted for inflation, but stocks (in the
  long run) keep pace
• AIR 5 683/mo (8.2 initial withdrawal rate)
• AIR 3.5 592/mo (7.1 initial withdrawal rate)
• Income stream is variable

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Why is Vanguard So Generous?

• Because you might die.
• When you manage your own portfolio, you assume
  longevity risk
• Just like self-insuring your house
• When Vanguard insures you, you are pooled with
  everybody else
• Some winners live to 99
• Some losers check out early
• It all evens out and the average age of 82.5
  determines payout rate

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Bad reasons why we dont love annuities

• I want to leave something to the kids
• OK, split your portfolio and annuitize half of it
• I might die too soon
• Joint annuity provides for spouse
• Period certain gives as much protection as you
  wish (at a cost)
• Im worried about inflation
• Buy an annuity with an inflation escalator
• The insurance company might go broke
• Choose variable payments based on your portfolio
  balance
• Buy two or more annuities from different
  providers
• Avoid surrender fees that lock you in
• My employer offers a lousy pension (or might go
  broke) I took the lump sum
• Use your lump sum to buy an annuity from Vanguard

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The mental barriers

• Mental accounting viewing risky decisions in
  isolation
• will I live long enough to get my principal
  back?
• But in retirement the financial risk is living
  too long, not dying too soon an annuity reduces
  risk
• Loss aversion
• Overestimate small probability of large loss from
  early death
• Possible loss is more painful than equally likely
  gain of living past predicted age
• Regret avoidance
• Annuities are illiquid. What if you change your
  mind?
• Loss of control
• Overconfidence
• I can beat the market
• No Black Swans for me, thank you (I know the
  unknowable unknown)

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Should you annuitize?

• Who shouldnt
• Income from portfolio meets your living
  requirements (with margin of safety for poor
  investment performance)
• Health issues eliminate longevity risk
• Strong need to maintain liquidity
• Already have ample annuity-like income stream
• Who should
• Investment income does not meet living
  requirements
• Average or better health
• Can commit to long-term strategy (low liquidity)

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Book Shelf
Leigh Anderson

• This presentation http//tayara.com/hia
• Vanguard websiteOverview http//www.aigretirement
  gold.com/vlip/VLIPController?pageOverviewCalcula
  tor http//www.aigretirementgold.com/vlip/VLIPCont
  roller?pageSubmitQuote
• United States Life Tables, 2003, CDC,
  http//www.cdc.gov/nchs/data/nvsr/nvsr54/nvsr54_1
  4.pdf
• Behavioral obstacles in the annuity market,
  Financial Analysts Journal Dec. 2007
• American Association of Independent Investors
• Investment Products If It Has to Be Sold, Dont
  Buy It! http//www.aaii.com/includes/DisplayArtic
  le.cfm?Article_Id3275
• Annuities The Good, the Bad and the Ugly
  http//www.aaii.com/includes/DisplayArticle.cfm?A
  rticle_Id2901
• What You Need to Know About Immediate Annuities
  http//www.aaii.com/includes/DisplayArticle.cfm?A
  rticle_Id3135
• What I did on my vacation www.tayara.com/travels

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Deferred Variable Annuity

• Advantages
• Tax-deferred growth,
• A death benefit,
• The ability to convert the annuity into a
  lifetime income at a later date, and
• Creditor protection
• The tax-deferred growth feature is typically the
  sales pitch.
• Disadvantages
• High costs,
• All deferred returns are eventually taxed as
  ordinary income,
• Loss of potential to avoid taxes on capital gains
  by awaiting a step-up in basis at death or
  donating appreciated shares to charity,
• Inability to harvest losses to reduce taxes and
  loss of foreign tax credit,
• Early surrender fees,
• 10 penalty tax on withdrawals before age 59½,
  and
• Investors must bear the credit risk of the
  insurance firms.