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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35259  
Subject: Bond and F-I FAQS Part 5: Annuities Date: 1/16/2006 2:41 PM
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Fixed and Inflation-Adjusted Annuities

Why Would Anyone Want an Annuity?

----Annuities have been aggressively hyped, by the insurance industry and some financial planners and advisors, because of the high stake typically taken out for “costs,” compared to many do-it-yourself investment options. Naturally, this has led those of us who view such costs as excessive to dismiss annuities as “bad-buys.” Usually, this dismissive attitude is well warranted—the circumstances where putting after-tax money into an annuity to shelter the returns until retirement (when even stock dividends and capital gains will be taxed at your marginal rate) for an extra 1% expense ratio on the same stock or bond fund will be a winning choice are be few and far between.
-----However, “annuitizing” (converting to an annuity, buying an annuity with other assets) a certain portion, or in some cases all, of your assets may be a helpful or even necessary strategy for those, typically retirees, who have reached a point when they can no longer live off their “earnings” (interest, dividends, capital gains) and must start drawing down principal to cover expenses.
----Even if a retiree starts retirement with more than sufficient earnings to cover, together with Social Security and, perhaps, a pension, all expenses, increasing expenses from inflation will inevitably overtake the earnings, even if the rate on earnings is also increasing with inflation. For example, someone with initial expenses of $72,000 and a nest egg of $1,600,000 earning $80,000 at 5%, with 3% inflation would end up flat broke in about 25 years (given certain assumptions about taxes and type of account). See TMF's Inflation calculator to crunch your own numbers.
http://partners.financenter.com/motleyfool/calculate/us-eng/retire02k.fcs
----In the above example, the retiree's expenses would start exceeding income after about 10 years, and it would all be downhill from there. As Mr. Micawber famously states, “Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery” (David Copperfield. Chap. Xii).
----If we could “market-time” our deaths to coincide with when the money runs out, the result would always be “happiness” (other than the minor inconvenience of being dead).
----The time “annuitizing” makes sense is at the point when expenditures start to exceed income (earnings).
----Annuities are an insurance product aimed at protecting us from the misery of outliving our money.
-----Annuities insure you will have a steady income stream, even if you live past the point when you would otherwise have run out of money.
----Naturally, being an insurance product, you have to pay for this steady stream of income by receiving a lower stream of income than you would have on your own if you died when the actuarial tables predict (insurance companies give themselves about 3 years' leeway). In order to get the maximum stream of income, you will also have to sacrifice the right to leave an inheritance, though there are usually ways of setting up an annuity that allow some inheritance in exchange for a lower stream of income.

What Kinds of Annuities Are There?

----There are a wide range of annuities available, including variable annuities that annuitize a variable portfolio (such as a stock fund, bond fund, balanced fund, or some combination), letting you withdraw a higher percentage each year than you could without annuitizing, but within limits set by how well your investments did in that year.
----From a “fixed income” perspective, what are of more relevance are variations of “fixed-annuties” in which you receive a guaranteed amount of money based on your investment and the terms of the annuity.
----For a couple, wanting to insure money will be available for a surviving spouse, there are versions of annuities set up specifically with that in mind.
----A true “fixed annuity” will provide the same income through the life of the annuity. The initial payments (for a given investment) will be higher than for other options, but will not keep pace with inflation.
----An inflation-adjusted annuity (which is basically what Social Security currently is) will increase the income stream to cover inflation, obviously beginning with a lower payment than a true fixed annuity.
----Another alternative is a fixed-annuity with periodic adjustments at pre-set amounts (i.e., you are guessing what you will need to cover your real inflation needs, since the official, CPI adjustment, may be a misfit, because of health-care costs, for example).
-----Since Vanguard, which along with TIAA-Cref is known for negotiating with insurance companies relatively low cost annuities (none are cheap) has an easily accessible, anonymous, calculator, without having to risk inquiring of an insurance agent, we will use that to look at some examples: Vanguard uses American International Group. (These are quotes as of 08-20-05 and subject to change.)
http://www.aigretirementgold.com/vlip/VLIPController?page=RequestaQuote
----An individual male who buys a fixed annuity through Vanguard with $500,000 at age 70 with no survivor benefit will receive an annual payment of $43,422 (over 8%); for a female it would be $40142.76 (women live longer).
----If the individual male instead buys an inflation-adjusted annuity, the initial payment will be $32,486.16 (about 6.4%); at 3% inflation, this will be pay more than the fixed annuity in about 10 years, but if you figure in earnings on the extra money from the fixed annuity at the start, the real break-even point will be a couple years later; with more or less inflation, the break-even date will be sooner or later.
----An inflation-adjusted annuity in which the surviving spouse of the same age receives 75% will give an initial payment of $26,362.44 (about 5%)
----A “fixed” annuity, with an annual 5% increase, with 75% surviving spouse benefits will give an initial payment of $22,137.48 (about 4.4%).
----There are numerous variations, with different income streams, that can be explored through the link.
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