I have always been against annuities. The first link explains why you should never buy an annuity. But the second link about the new rule where you can purchase up to $125,000 of a deferred annuity with IRA money that won't go against your RMD sounds compelling to me. Playing around with an annuity calculator, I see that at age 70 a 15 year $125,000 deferred annuity pays out some $4600 monthly (over $55,000 annually) beginning when I am 85. Yes, I know many/most of us males, including me, may never make it to 85 or much beyond, but it still sounds compelling. Instead of worrying about the next 25 to 30 years and outliving our nest egg, I would think this would narrow our focus to only the next 15 years (before the annuity kicks in) and doing the right things financially in our investments. What am I missing here? I will say, were I to ever purchase an annuity it would ONLY be through New York Life.
http://www.forbes.com/sites/davidmarotta/2012/08/27/the-false-promises-of-annuities-and-annuity-calculators/http://taxvox.taxpolicycenter.org/2014/08/01/new-way-invest-old-age-many-will-buy/
Comments
But many people don't perceive that value, nor do many investment writers. Rather, they look at the possibility that you'll lose money by dying. (Personally, I think the dying early part is the bigger loss
That's not to say that many, if not most, annuities are not overpriced. They're designed to make money for the insurance company that does deserve a fair payment for providing the product and spreading the risk among a large pool of policy holders. But they're also designed to pay for salespeople, who have a real hurdle in explaining what these policies can and can't do for you. Unfortunately, the high commissions, aside from compensating for this effort, also serve as incentive to oversell.
My preference is to stick to as close a vanilla plan as one can - avoiding extra costs that IMHO are for features designed more to make the product attractive to the naive customer than to add value. Also, stick with first rate insurers - they're going to have to be around to pay off that annuity decades from now (hoping you live that long). NYLife is a great company in that respect.
My one paragraph summary: I think many (if not most) annuities are overpriced, and overladen with features. That doesn't mean the product is intrinsically bad, just that you need to be careful, and understand what your objectives are. I also think that longevity insurance is one of the few really useful innovations in annuities. I'm still thinking through the idea of incorporating a longevity policy inside an IRA; I think it can help deal with RMDs (in your 70s) that would otherwise be too high, but haven't worked those numbers yet.
Side note: I've gotten a couple of emails asking/suggesting that I might be somewhere in the financial industry. I'm not. I'm just very fortunate to have had wonderful supportive parents (with a scientific/mathematical bent), some good teachers (and some awful ones), and a personal inclination toward numbers and rational thinking.
In 15 years 125,000 will double to 250K at 4.8%/year
rule of 72
72
15 years
4.8 %
So the question is - what is the % the 125 is growing at and how much of the 55 is return of principal so we can calculate the annual return.
When I looked at annuities they didn't compare favorably with junk bond funds.
So from age 70-85 your term life policy covers the costs of the annuity in case of "early departure". At age 85 the annuity kicks in.
As I mentioned before I think my small pension and SS does give me some peace of mind.
@Dex - regarding the IRR (rate of return). From one perspective (especially on the insurer's side), the calculation is a lot more complicated, because the payout is not for a fixed term of years, but a life expectancy. This involves actuarial tables, probabilities, analysis of customer base (purchasers will self-select for longer lifetimes), etc.
From your perspective, perhaps the calculation is simpler - you know your health, and are much more able to treat the annuity as a fixed term of years, even if this is just an approximation.
In that case, the formula is relatively simple (but there's no closed form to compute the solution, i.e. IRR; a computer can calculate it by iterative approximation).
Let M be the number of years until payments start, and N the number of years of payments. Here, M is 15 (buy at age 70, start payments at age 85). Pick your own number for N.
By definition, the present value is the purchase price PP ($125K), and what you're interested in is the rate of return. You've got the right idea ... the value at year M (when payments start) is
PP * (1+r)^M = $125K * (1+r) ^ 15.
There's a standard formula for the value (price) of an annuity with N payments of $C ($55K). You can find it in a pretty nice paper here. It is:
PV (present value at start of payments) = C/r * [1 - 1/(1+r)^N] = $55K/r * [1 - 1/(1+r)^N
So we set these two expressions, representing the value of the annuity at the time payments start, equal to each other, and solve.
$125K * (1+r) ^15 = $55K/r * [1 - 1/(1+r)^N] or
$125K * (1+r) ^15 - $55K/r * [1 - 1/(1+r)^N] = 0
(In case it matters, you can see this is a polynomial equation by multiplying both sides by (1+r)^N and by r to clear the fractions.)
So now you're left with an algebra problem in the form: f(r) = 0.
You want to find the real root of this equation with r somewhere between 0% and 20%.
There are various mathematical packages that will do this for you, e.g. Matlab's fzero function. If one is into programming, there are simple iterative methods to find roots, e.g. bisection and Newton's method. See, e.g. http://www.math.niu.edu/~dattab/MATH435.2013/ROOT_FINDING.pdf
Or you could look for online solvers. A quick search for online bisection method calculator turned up http://keisan.casio.com/exec/system/1222999061
(Bisection is slower, but you don't need to provide the derivative of your function as you would for Newton's method.)
I tried this calculator for N=10 (payments to age 95) and came up with 7.61% rate.
With N = 5 (payments to age 90), the return is 4.49%.
(Use ^ for exponent and * for multiplication, as I did above. Also use a range between 0.01 and 0.2 - to avoid dividing by zero - see the $55K/r in the expression above. Finally, replace r in my expression with x for this calculator.)
That may be what you're missing - the age 85 part.
-
Thanks for the links Junkster. Both sides make compelling cases.