Retirement Annuities: Do They Make Sense?

by: Lowell Herr

An August 7th article in The Sunday Oregonian caught my eye with this title: Is an annuity right for you? Well, probably not. The article laid out a story where the North American Company for Life and Health Insurance sold a 66 year-old man (named in the article) an annuity for $150,000 that would provide him an income of $1,000 per month until he dies. The annuity was to begin immediately. The article also stated that low interest rates will now only buy a $900 per month annuity with the same investment.

The mental wheels began to spin to figure out the last part of the title, "Well, probably not." Peeling off $1,000 per month from $150,000 placed under the mattress will last 12.5 years taking the 66 year-old up to age 78.5. Government actuarial tables show that a 66 year-old male is expected to live 16.5 more years, or until age 82.5. The insurance company needs to earn enough to span the 4-year gap. A little spreadsheet work shows covering this gap should not be all that difficult, Since we are dealing in probabilities, a Monte Carlo analysis is in order to answer the basic question of whether this annuity makes sense.

In the analysis below, the income oriented portfolio consists of ten ETFs. Treasury, TIPs, U.S Equities, REITs, junk, Intermediate and short-term bond ETFs populate this conservative portfolio. This is not a "normal" portfolio. Rather it is designed to throw off income to bridge the four year gap. Will it work?

Assuming an inflation rate of 3.5% and a growth rate of 5% (low assumption) for the S&P 500, this portfolio has a 10% chance of running out of money by age 75. That number was a surprise. Why should a very conservative portfolio, generating income, not provide better protection? One only needs to think of setting up an annuity in March of 2000 or November of 2007. Those are the risks undertaken by the insurance company. In addition, they worry about the inflation rate, set at 3.5% in this analysis, plus all their overhead costs. Overhead expenses are not considered in this example.

Check the probability results shown below.

While my first reactions to the $1,000 per month annuity was negative, upon further examination, it is a reasonable contract. The $900 per month contract is less so.

The "do-it-yourself" investor does not want to risk that 50% chance of running out of money by age 78. Certainly not if this is the only source of income. What changes need to be made to alter the above probability numbers if the investor wishes to go it alone?

  1. It is important to promise yourself not to withdraw more per month than would have been paid by the annuity holder. The annuity route provides this protection.
  2. Diversify the portfolio across more asset classes.
  3. Increase exposure to equity markets, both domestic and international.
  4. Include emerging markets.
  5. Consider commodity ETFs.

To stretch out the longevity of the portfolio and reduce the probability of running out of money, one needs to increase the portfolio risk. If taking on additional risk does not fit the personality of the investor, then considering an annuity as described in The Sunday Oregonian makes some sense.

Disclosure: I am long VTI, VNQ, JNK, RWX, TIP, TLT, IEF.

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