How Annuities Can Shine in Risky Markets

Market swings make the safe returns of fixed annuities more appealing to older investors.

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In booming markets in which all investments seem to move upward, fixed annuities fall by the wayside. Fixed annuities promise modest returns and may have costly fees. The products offer guaranteed returns of principal, and thus function in part as a life insurance policy. But such guarantees can be cheaply secured with low-cost term life insurance, freeing up investment funds that can be placed in more attractive holdings.

[See 10 Steps to Fine-Tune Your Retirement Plan.]

Today, of course, investment markets are limping, not booming. They also are prone to large swings. Interest rates are so low that other safe, yield-based investments are unappealing. Low rates also reduce the promises that insurance companies can make on annuity returns. Even so, sales of these "plain vanilla" annuities have been rising.

Second-quarter sales of fixed annuities rose nearly 8 percent from the first quarter, to $20.4 billion from $18.9 billion, according to Beacon Research. Low interest rates did depress some types of fixed annuities. But sales of indexed annuities, whose returns are keyed to well-known investment indexes, more than made up the difference. They jumped 30 percent during the quarter and accounted for 40 percent of all fixed annuity sales.

Moshe Milevsky is a finance professor and annuity expert at York University in Toronto. He has long extolled the virtues of annuities and, in a recent article for Research Magazine, provides a clear framework for how to compare annuities with other investment choices.

Milevsky uses the example of a 65-year-old person who wants to retire now. After accounting for income from Social Security and private pensions, the person figures he or she needs an additional $1,000 a month, or $12,000 a year, to retire. This income also needs to increase each year to reflect the impact of inflation. The amount of money that's needed to produce $1,000 a month in inflation-adjusted dollars is, in Milevsky's view, the real cost of retirement.

[See How to Use Annuities for Retirement Income.]

One big question, of course, is how much longer our hypothetical 65-year-old is going to live. There may be estate considerations on top of longevity issues but for the purposes of this comparison, only the monthly income until death is considered. Milevsky looks at three longevity outcomes—average life expectancy for a 65-year-old (84.2 years), the 25 percent chance that the person would live to 90.1 years of age, and the 5 percent chance that the person would live to the age of 97.1 years.

A second big question is how much money the person's investments would earn each year. Milevsky looks at four sets of annual, post-inflation returns: zero percent, 1.5 percent, 4 percent, and 6.5 percent.

He then calculates the size of the nest egg needed to generate monthly income of $1,000, adjusted for inflation, and compares this with the current cost of buying a lifetime annuity that produces that $1,000 by guaranteeing a post-inflation return of 1.5 percent a year. Because of low interest rates, this is the best deal currently available on such an annuity, he says. "We all might believe this is artificially low," he says, "but it is the best you can get if you want something that is guaranteed."

This annuity guarantee is not offered by other investments, which is a big selling point of annuities. Annuity guarantees are not backed by the government but by the individual insurance company that issues the annuity. There are state-funded insurance plans to backstop annuity guarantees, but insurance companies have posted an excellent record of paying their annuity obligations.

[See When to Convert Your Savings Into an Annuity.]

The other selling point of the annuity is that you get the payments as long as you live; there is no mortality risk. (If you want to insure against dying early, you can get an annuity that will pay income to a surviving spouse or for a minimum number of years. You will need to pay for that certainty in the form of a higher payment for your guaranteed $1,000 in monthly income.)

Using these variables, Milevsky is able to produce a table showing how much money needs to be set aside to achieve each scenario:

Cost at Age 65 to Produce $1,000 in Monthly Income for Life
    Annual Return After Inflation
Planning Time Frame Age 0.0% 1.5% 4.0% 6.5%
Live to Average Life Expectancy 84.2 $230,490 $200,300 $160,900 $131,600
25% Chance of Living to 90.1 $301,700 $251,300 $190,300 $148,600
5% Chance of Living to 97.1 $385,100 $305,600 $216,900 $161,700
Lifetime Income via Fixed Annuity N.A. N.A. $230,000 N.A. N.A.
           
Source: Moshe Milevsky        

The table, he notes, "is a basic application of the time value of money, given today's interest rates." People will look at the low-return, larger nest-egg set-asides and wonder if this is the best they can do, he says. They will look at the higher-return scenarios that require smaller nest eggs and be drawn to them. The difference, he stresses, is that the higher return projections also carry higher risks. If you want to bet on higher returns, go ahead, but keep in mind that you are betting. And the bet is much riskier at the age of 65 than 35.

"If you are going to assume a higher expected investment return—like 6.5 percent—compared to what is available with no risk, then you must also allow for the possibility that things will not work out and you might earn much less than expected," Milevsky says. "Average the two scenarios—and account for this risk properly—and you are left exactly where you started, namely the present value of your $1,000 under a risk-free return is $230,000 if you plan to life expectancy and $385,000 if you plan to the 95th percentile."

"If you don't like how big this number looks—and you want certainty—then save more, retire later and plan to spend less," he advises. "Assuming or expecting or anticipating 6.5 percent or planning to age 90 only won't solve a structural funding problem."

Milevsky goes further in his support for annuities. "The annuity price is actually a market signal of what retirement really costs," he says. "And, it is the cheapest and safest way to convert a nest egg into a lifetime of secure income. Market prices convey information and the cost of a life annuity is a "hard drive' full of intelligence."

Twitter: @PhilMoeller