Annuities

In recent blog posts we touched on Term Life Insurance and Permanent Life Insurance, both of which are intended to compensate the purchaser in the event of an untimely death. However, for those without a defined benefit pension plan (most people), running out of money in retirement, or longevity risk is a valid concern. Annuities are longevity insurance, guaranteeing a steady stream of income for life. Read on for details…

Annuity Basics

The easiest way to think of an annuity is that it is the opposite of life insurance. With life insurance, you pay an insurance company a steady stream of premiums in exchange for a lump sum payment when you pass on. Actuaries at the life insurance company calculate the probability of dying before each age, and determine the premiums you would pay accordingly.

With annuities, you pay an insurance company a lump sum in exchange for a steady stream of income until you pass on. Similarly, actuaries at the insurance company calculate the probability of living past each age, and determine the premiums accordingly.

Why Annuities Make Sense

Even if the average life expectancy is 85, you don’t know if you’ll live to 75, 85 or 95. When you manage your own investments, you need to be conservative in planning, and may even need to budget for living past 100!

There is a rule of thumb that if you invest retirement savings yourself, you can safely withdraw 4% of your capital every year with only a small chance of running out of money. However, this means that to sustain an income of $30,000/year, one would need to save $750,000. Few people are able to save this much.

This is where the insurance company steps in. While they don’t know how long a specific person will live, they can estimate, in aggregate, what the life expectancy of a group is. The insurance company pools together the money from individuals of various ages, for example, 65-year-olds, and can then pay out about 6% per year to each person in that group, because some people will live to only 75, most will live to about 85, and only very few will live to 100. As a result, due to the insurance company pooling the money for individuals, for the same $30,000 annual income, only $500,000 would be required.

Annuity Options

There are a few options that are available with some annuities. Not all are offered with all insurance companies. Below is our subjective opinion on the usefulness:

• Joint Life: if you have a spouse, this may be a good choice. Payments continue until both people pass away.
• Term-certain: guarantees that the annuity will be paid out for a certain minimum time, potentially to beneficiaries. This option will lower the payout rate of the annuity, and is often useful in only a handful of cases, such as death before expiration of the annuity. It would be unfortunate to die shortly after setting up an annuity (or in general); however, life insurance should be used separately to mitigate that risk.
• Inflation-indexed: the payout of the annuity will increase with inflation. The value of currency has been eroded by about a quarter every decade due to inflation. This means that in 20 years, the $30,000/year annuity will only buy about $17,000 worth of goods! While buying an inflation-indexed annuity may seem expensive, not buying one may end up costing a lot more.

CJ Capital is not a licensed insurance broker, nor are we affiliated with any financial institution. Contact us if you have a few insurance products in mind and would like an unbiased 3rd-party opinion.