Explaining and Measuring Return

October 8, 2014 by Lowell Aronoff

FROM AN INCOME ANNUITY

PART TWO

In this final article of a two-part series, we’ll discuss quantifying the value of an income annuity by comparing it to more common investment products and strategies.

As you know, many retiring clients have spent their financial lives accumulating a nest egg. These retiring clients may feel that allocating a portion of their retirement savings toward a product that pays them a check every month is an investment. So it’s natural to utilize accumulation metrics such as “yield” to compare different products. In the first part of this series, we included a hypothetical example showing how a lifetime income annuity could benefit a healthy 65-year-old woman with a $100,000 premium. As you may recall, the lifetime income annuity with a 10-year guarantee would pay about $525¹ per month, and we could graph the client’s future yield against various ages when she might die.

We showed that her yield at life expectancy was very close to the yield (net of commission and expenses) of that of a similar high-quality, long-term bond fund. This ignores, however, the insurance element of income annuities. Instead it’s asking: Should our client…

1. Buy an income annuity or purchase a different product now?

2. Buy an annuity at a future date when it is “cheaper” because she’s older?

Also, in the previous article, we showed how — by using the Implied Longevity Yield^TM (ILY) tool — it is hard to beat the return from an income annuity for a 65-year-old client. Keep in mind that ILY assumes future interest rates will not change from their current lows. So another question may arise: If the client feels interest rates will increase in the next few years, should she purchase an income annuity now or wait?

Income annuity rates are driven by a yield curve not dissimilar from the Treasury Yield Curve. Let’s examine a case where we assume that in five years, the client will be able to purchase an annuity based on a yield curve that is as good as the best rate that has been available in the past 10 years. CANNEX publishes an index of income annuity rates called the CANNEX Payout Annuity Yield Index (PAY)^TM. In the past 10 years, PAY^TM rates peaked in 2009 according to this index, as shown in the chart below.

The client will be five years older when these hypothetical (assumed and fictitious) rates become available. Would she be better off waiting?

There are a few more assumptions needed to round out this. To make the scenarios fair, we need to assume a few factors in both cases (buying now versus waiting):

1. $100,000 of retirement savings would be allocated for the purchase.

2. The monthly withdrawal amount would be the same at $525.

At the end of May 2014, the Treasury was showing a yield curve for one-, five-, 10- and 30-year rates of approximately 0.25%, 1.5%, 2.5% and 3.5%, respectively. We will assume that the client chooses to invest in the five-year Treasury while waiting. Remember that Treasury rates peaked in June 2008 at approximately 2.5%, 3.75%, 4.25% and 4.75%, respectively, as shown in the “Projected” rates on the next page. In other words, would the client regret her decision to wait five years to purchase an income annuity if rates at that time were more favorable than they have been in the past 10 years?

The math is difficult, but the tools to calculate these “what if” scenarios are available. In this case the client would be slightly better off purchasing the annuity now. However, if she could find an investment that is as secure as a guarantee offered by an insurance carrier, flexible enough to allow monthly withdrawals, and paid 2% while she waits, she may be slightly better off waiting.

Based on the hypothetical example on the next page, it is clear that the yield generated by an income annuity should not deter a 65-year-old client from purchasing an income annuity. Yield is an intangible concept that is very useful in the client’s accumulation years. Once retired, she will probably be more concerned about tangible concepts like having a large enough monthly check to cover her needs. In other words, the client should be less interested in knowing what the yield is on her investment and more focused on knowing whether her overall strategy can and will continue to generate the income she needs and meet her other objectives.

The most common strategy in use today is a Systematic Withdrawal Plan (SWP). A consideration that is far more tangible than yield is whether adding an income annuity improves the outlook of an SWP that pays 4% per year, increasing with inflation.

Let’s go back to our example and suppose that the client has $400,000 in investable assets in a 60% (equities)/40% (bond) portfolio. She wants to know whether the purchase of a $100,000 income annuity can help her improve her retirement. For the purpose of this illustration, we will assume that her return from equities will be consistent at 5%. We’ll also assume that her bonds will yield a consistent 2.5% and inflation will run at 1.5%.

Purchasing the income annuity involves a trade-off, as does purchasing any investment or insurance product. Because she has transferred the risk of depleting $100,000 of assets to an insurance company, and the annuity provides $6,300 per year — substantially more than the $4,000 — she could withdraw from that portion of the SWP. She can spend more in retirement without increasing her risk of depleting assets. This additional amount that the client can spend accumulates with time and is highlighted by the blue line below. However, if the client ends up living a short life, her estate will be less valuable than it would have been had she not purchased the annuity. This decrease in her estate is represented by the red line below. As you can see, the longer the client lives, the smaller the cost to her estate will be for purchasing an income annuity.

The distance between the two lines represents the financial benefit (on the right side of the graph) or financial loss (on the left) from the purchase of the income annuity. In other words, if the client lives 20 years (where the lines meet) or more, there would be a financial benefit to owning the income annuity. Statistics tell us that if this client is in good health, the likelihood that she will live another 20 years is 68%.

While the income annuity provides clients with a very competitive yield, a far more important financial consideration is whether it provides the client with the ability to safely withdraw more money from her portfolio. In this case, it does. There are also nonfinancial considerations. Would the income benefits guaranteed by a financially strong insurance company help give the client peace of mind? Do her children have valid concerns about having to support a potentially penniless mother? Will she maintain her ability to make financial decisions as she enters extreme old age? Would the reduced need to worry about where her money comes from lead to a potentially happier retirement? If the answer to some of these questions is yes, then it’s time to consider an income annuity.

Originally Posted at NAFA Annuity Outlook on September 2014 by Lowell Aronoff.