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The best way for retirees to increase their lifetime monthly payments is to defer taking Social Security. The profits from this strategy exceed those of reasonably safe alternative strategies.
But some investors want more. Among their options are immediate annuities that provide monthly payments for either the remainder of the purchaser’s life, or the life of the couple if structured as a joint survivor benefit. When purchased in a lump sum, such a contract is called a “single payment immediate annuity” or SPIA. (Note: There are many different types of annuities, most of which are initially used to accumulate assets rather than pay out. But we’ll discuss those another time.)
Case Study
Obtaining pension estimates without interference is not easy. Many websites that claim to offer this service are marketing tools that collect data on potential customers for insurance brokers. However, there are several places where consumers can browse. One is blueprint incomethe other one is by Charles Schwab. pension calculator, used in this article. For example, when a single 62-year-old man living in Illinois asks what his monthly payments would be on his $100,000 purchases, Schwab’s software answers $606, giving him a payout rate of 7.27%. Become.
Lifetime repayment amount exceeding 7% per annum! Who would object? However, that benefit requires context. First, pension payments include the investor’s capital and the insurance company’s contributions. Therefore, this 7.27% figure is not a total return and may not be directly comparable to investment performance.
Second, this particular contract does not protect against the possibility of early death, so it only provides a positive benefit if the retiree lives long enough to use the insurance company’s money, not just his own. . Exactly how long is not intuitive. However, by evaluating the potential outcomes using actuarial tables, you can arrive at a general sense of the benefits of the contract.
social security forecast
The following graph shows the cumulative probability of death for a hypothetical investor, as predicted by the Social Security Administration. The probability that a retiree will die within the next year is 1.6%. The probability reaches 25% immediately after his 73rd birthday, 50% at the age of 81 and 75% at the age of 87.
If you do the math, our sample annuity is clearly at a disadvantage for short-lived buyers. According to Social Security projections, a retiree has a 25% chance of expiring within the next 11 years, at which point his $100,000 contract will have paid him up to $80,000.In such cases, like Georgie Best I told youOur retirees might have been better off spending their money wisely on “booze, birds, and fast cars” instead of wasting it.
The median results aren’t particularly appealing either. Looking at the back of the envelope, the original capital will last him 14 years, and the insurance company will supply him with only 5 years left. You don’t need a calculator to see the inadequacy that a $100,000 expense would generate him $138,191 over his 19 years. Sure enough, Excel revealed that the internal rate of return in that situation was a modest 3.87%.
insurance company model
What gives? Indeed, competition has meant that insurance companies selling such contracts are not only not competitive with Treasury bonds for the median purchaser, but also have better returns, rather than negative returns for 1 in 4 purchasers. You will be forced to provide conditions.
My intuition is correct. In fact, our sample annuity is affordable. As Morningstar annuity expert Spencer Look explains, a key consideration is that retirees who purchase immediate annuities tend to be much healthier than the norm. As a result, the expected returns from their purchases are significantly higher than the Social Security Administration’s projections.
The graph below shows the life expectancy of an immediate annuity purchaser as estimated by standard insurance industry mortality tables (each insurance company uses a different model, but this is a representative case) and the social This compares the average life expectancy assumed by the National Security Bureau.
Not at all! From the insurance company’s perspective, the 25th cumulative mortality percentile is not reached until he is 79 years old. The 50th percentile is not reached until he is 7 years old and the 75th percentile is not reached until the retiree reaches his 92nd year. Under these conditions, a lifetime annuity is much more advantageous. Currently, the median internal rate of return for buyers is 5.44%, which is much higher than what Treasury bonds achieve.
Incorporating cash refunds
So far, so good. However, one very big caveat remains. While most retirees who match the insurance company’s risk profile will be successful in purchasing their SPIA, the unlucky few will die before the principal is used up and the performance will be very poor. Fortunately, this shortcoming can be corrected through a cash refund rider. Such clauses provide that if the annuitant dies before the specified date, the unused capital of the contract passes to the beneficiary.
All things being equal, the cash refund feature greatly increases SPIA’s appeal.Of course you would expect everything to be do not have This is because insurance companies will significantly reduce SPIA payments to cover the cost of benefits. Think again. (It certainly did.) According to Schwab’s calculator, there is little yield reduction when he adds a 10-year cash refund rider to the sample contract. Doing so will reduce his monthly pension payments from $606 to $595, which will reduce his annual percentage rate from 7.27% to 7.14%. It’s hardly worth noting.
In effect, the 10-year cash refund rider provides the closest thing to a free investment lunch. My former colleague David Blanchett, now head of retirement research at wealth management firm PGIM, explains why: Actuaries who work for insurance companies know that customers who are concerned about cash-back provisions are more likely to have health concerns. As a result, they price such contracts more aggressively.
conclusion
The result is simple. For most investors, the expected rate of return on immediate annuities is relatively low. That’s because these contracts are priced for (and typically purchased by) unusually healthy customers. Still, in some cases, such an annuity can be a wise choice since it is insurance after all. Not all insurance contracts need to be “profitable” to achieve their purpose.
That said, SPIA clearly makes the most sense for people who have reason to believe that both their genetics and lifestyle allow them to enjoy a longer-than-average lifespan. It would likely be even better if there was a cash refund clause. In most cases, the cost of such a deal is significantly lower than the benefits provided.
The views expressed here are those of the author.
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