| |
As more companies do away
with their pension programs, the insurance industry and the media
are heavily promoting the use of immediate annuities to provide a
dependable income stream during your retirement. But is that in your
best interest? Normally, I say it is not. Read on to find out why.
An immediate annuity is one where you pay an insurance company a
lump sum in return for a stream of income. You can decide if the
income stream is guaranteed for a certain number of years (period
certain), for a set number of years or your lifetime—whichever is
greater; and whether your spouse should receive benefits for his/her
lifetime after your death. Since you can receive a set payment for
life and can also provide for your spouse after your death, this is
seen as a ‘perfect’ pension replacement.
There are four main reasons that I don’t advise this.
First, when you buy an immediate annuity you exchange a lump sum for
a series of monthly payments. The lump sum is gone…forever. At that
point your return is dependent on how long you and/or your spouse
live (unless you chose period certain). If you live longer than the
life insurance company expects then you get a higher overall return
on your investment. If you die before then your return drops
considerably.
For instance, Jack and Jill are both 62 and buy a joint life annuity
for $250,000. In return, they’ll receive $1468 every month for the
rest of their lives, regardless of who dies first. After the
remaining spouse dies, that’s it. Nothing goes to your children.
Assuming their joint life expectancy is 85 years old, the internal
rate of return on the annuity is about 4.6%. If they both die at 75
years old their average annual rate of return is negative 1.3%. If
at least one of them lives to age 95 then the return on the
investment was 6.1%. So your expected return is 4.6%, but your
actual return may be more or less.
That illustrates another reason that I don’t think people should
annuitize—all they are doing the first so many years is getting back
THEIR money. Picture putting that same $250,000 under your mattress.
Then each month you reach in and pull out $1468. You wouldn’t run
out of money until 14 years later! That’s if you aren’t earning
interest on it.
If you just put the money in a money market earning 3% you could
keep using it until age 80. Interest rates have been going up and
some money market accounts are paying 4.75%. Use one of those (or
buy a 30-year Treasury bond) and you would cover the payments until
one of you reached 86.
There are other benefits of not annuitizing. If your situation
changes and you want/need access to more than the $1468 a month, you
have access to the remaining principal. If you die before the money
runs out the remainder can go to your children. The return you
receive isn’t based on how long you live but on how it is invested.
Over time, inflation is your greatest risk. Jack and Jill’s annuity
payment does not increase for inflation each year. If it did, it
would be much lower to start with. Doing it yourself allows you to
increase your payments over time if needed and/or based on your
return.
Obviously, I feel there are better ways to invest $250,000 than
putting it in a money market or CD. Over a similar period of time, a
well-managed, well-diversified portfolio of stocks, bonds and real
estate should average 8% or more. If so, you can meet the same
income payment, adjust it for inflation and possibly never even
touch your principal. Even if you end up using some principal, the
chances are much greater that there will be money leftover for your
heirs.
Some would rather let an insurance company bare the risks for them.
There are risks to doing it yourself: interest rate risk,
undisciplined spending, market risk, etc.. But these are easily
mitigated in a well-managed portfolio, and are far outweighed by
your ability to earn a higher return while maintaining access and
control of your money.
Have a financial question? Send me an email and I’ll personally
respond, free of charge. Go to www.guardingyourwealth.com and click
on ‘Ask Jeff’.
In addition to being a nationally syndicated columnist and Certified
Financial Planning Practitioner, Mr. Voudrie provides personal,
private money management services to clients nationwide. |
|
