Is an Annuity Right for Part of Your Retirement Funding?


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top.  The posts will appear in reverse order, with the newest post first. 

I have recently gained a new appreciation for annuities, or at least the promise that an annuity holds.  At one point I swore off annuities entirely and there are good reasons to do so.  These include:

  1. You can do better investing the money yourself.
  2. The fees can be high.
  3. You generally have little flexibility once you have made the purchase, and may need to pay a big fee to receive any of the money back.

But then I realized the true purpose of an annuity is the same as it is for any insurance product:

To shift your risk to the insurance company in exchange for the cost paid.

All annuities pay you a specified amount of money for a specified period of time in exchange for you handing over a load of money to the insurance company.  For example, you give them $100,000 and they agree to pay you $500 per month for the rest of your life.  In many ways this is like a pension plan where you receive payments, except this is from an insurance company instead of an employer.  In fact, many employers that still have pension plans use annuities to make the payments once individuals retire so that they don’t need to worry about it.  They just buy an annuity that pays the former employee whatever is needed when they retire and then the employer’s part is done.  You can create your own pension using an annuity if you commit your 401k funds or other retirement savings.

Now while there are probably as many different kinds of annuities as there are stars in the sky, since they are all just insurance polices and the types are only limited by the imagination of the companies that create them, there are really only two types of annuities that should hold any interest for you.  These are immediate annuities and deferred annuities.  And here we just want the plain vanilla types – no bells and whistles.

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Immediate annuities are just that – you give them money and they immediately start making payments to you.  These are used to provide regular income without needing to worry about what the markets are doing, buying and selling mutual funds, or performing other actions.  Deferred annuities pay after you reach some certain date, for example, starting to pay you $5,000 per month after you reach age 85.  These are used as insurance against outliving your money.

So why are annuities not as good as investing yourself, in general?  The reason is both that they charge fees (which can be big) and the return you get from an annuity, including fees, will not be as great as you would get if you had invested yourself.  For example, if you were to invest $1 M at age 65 in a balanced stock and bond portfolio, you would be able to receive about $40,000 per year, indexed for inflation, until you were age 95.  At that point you would have on average about $2 M in the account and have received about $1.8 M in payments during that time.  The $2 M would be able to buy about what $1 M can buy today, so you would effectively have all of the money you started with, plus have received an income to fund a $40,000 (in year 2018 dollars) per year lifestyle.

If instead you were to put the money into an immediate annuity, you might start getting paid about $75,000 per year, fixed.  If you then died at age 95, you would have received about $2.25 M during that period.  This sounds better than the $1.8 M you received from the investment portfolio, but the insurance company would keep the money you gave them when you died, leaving nothing for you to pass on to your heirs or from which to pay for your final expenses.  You would have gotten $450,000 less in income from investing, but would have $2 M in savings remaining instead of nothing.  Because an account can withstand about a 4% withdrawal rate without declining in value over time, spending at this rate can be done essentially forever, assuming no black swan market event occurs.

In addition, while you would start out better with the annuity, receiving $75,000 per year instead of $40,000 per year from the investment account, by the time you were 95 you would be receiving about $80,000 per year from the investment account where you would only be receiving $75,000 per year from the annuity.  While your spending power would start out greater with the annuity, the payments from the investing account would pass it up along the way and you’d be having a little more trouble meeting expenses with the annuity near the end.

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So why would you want to have an annuity instead of just investing yourself?  The beauty of the annuity is that you would (nearly) eliminate the risk of a market drop affecting your income.  Annuities also help protect you in the case that you live longer than average since many of them pay income until you die.  In fact, you’ll be able to utilize more of your money while you are alive using an annuity than you would investing yourself because, while you would need to limit your withdrawals to make sure you didn’t run out of money before you die if you’re investing yourself, the insurance company knows that if they sell 10,000 annuities, the average age at which people will die and distribution of ages is predictable and they can determine with a fair amount of certainty how much they’ll need to pay out.  They are therefore able to provide a higher payout per month than they could if they were just insuring a single person who might live to be 115.  If they know from historic data that the average person would live to age 84, for example, and how many people will live longer, they can determine the maximum payout they can make and not lose money.

Note that if you die young, say at age 66 when you buy the annuity at age 65, the insurance company would probably keep your whole $1 M.  This makes up for the people who live to be 100 and withdrawal more than the insurance company can make from their investment.  This is the nature if insurance – some people pay for more than they use to make up for those who pay for less than they use.     

And therein lies the reason that some people would want to use an annuity and others should invest for themselves.  If you are interested in leaving a lot of money to your kids or a favorite cause and you have enough money saved to allow you to generate enough income for expenses using 3-4% of the value of your savings each year, invest yourself.  If you don’t want to leave money, yet you don’t want to risk running out of money either, use an annuity.  You could also do a little of both, using an annuity for a portion of your savings to gain the additional income, but keep some invested in stocks to provide growth to allow you to increase your income should you live a long time and inflation starts really affecting the buying power of your annuity payments.

As far as what an annuity can and should pay you. realize that the insurance company will invest the money, probably mostly in common stocks if they don’t use the money to underwrite other insurance policies,.  The most they could pay would therefore be equal to the withdrawal rate they could make for the average life expectancy and have the money last.  As an example, if a person who is 65 buys and $1 M annuity and the insurance company figures out that the average person in the buyers risk-pool is likely to live 30 years, they could pay about $5368 per month or $64,418 per year if they were able to make an annualized rate-of-return of 5%, or about $7337 per month or $88,050 per year if they were able to make an annualized rate-of-return of 8%.

The amount they would offer would be somewhat less than this since they would take a fee off-the-top to pay the person selling you the policy, plus the insurance company would want to make a profit from the policy to make it worth their time, plus they may want to pay a bit lower than they would expect to make in case the markets don’t perform well during the period and don’t return as much as they were expecting.  They might therefore offer you $4500 per month if they were expecting to make 5% instead of the $5368 per month that they were expecting to make investing the money.  If there is ample competition (and you should shop around to make sure you get the maximum pay-out you can while still using a solid provider), you should get a reasonable return and their profit should be reasonable for the risk they are taking and their costs.

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Annuities are also a great choice if you have not saved as much as you really should have.  For example, if you have only saved up $250,000 by retirement, plus you have a home worth $500,000, you could maybe downsize or move to a lower-cost area and pull $350,000 out of your home.  (You could also possibly use a reverse-mortgage if you wanted to stay in your home, but again you would be paying a lot of fees in doing so.)  You could then take the $600,000 you had available and maybe buy an annuity paying $3,000 per month, or $36,000 per year.  Combined with Social Security, you should be able to make it through, although it might get tight if you live a long time after retirement.  You should therefore work as long as you can and build up all that you are able before you retire.  This will both increase your possible pay-out and reduce the number of years you’ll be in retirement.

But what if you want to have a good chance of spending most of your money, but want to get a better return that you will from an annuity?  If you have saved enough to fund your monthly expenses from investment returns, there is a way that you can invest yourself and still use more of your money than you will if you limit yourself to a 3-4% withdrawal, yet still have a low chance you will outlive your money.  The secret is to start out conservative, but then increase your withdrawal rate as you go.

For example, if you had $1 M and retired when you were 65, you would start out at 4%, or $40,000 per year.  At this rate there is a good chance your portfolio value will not drop at all (in inflation-adjusted terms).  If you wanted to be even more conservative, you could limit yourself to 3%.  After five years, at age 70, you could start spending at a rate that would exhaust your savings in 30 years, assuming some reasonable rate-of-return.  For example, as shown before, a 5% rate-of-return would result in a yearly payment of $64,418 as shown before.  Because your chances of living to 100 are fairly low (depending on the ages of your parents when they died, your current health, and other factors), you are fairly safe increasing your spending and starting to spend down your savings at this rate.

If you are still worried, you could also take some of the money and buy a deferred annuity that kicks in at age 90 or something.  Since it is unlikely that the insurance  company would expect you to receive many (or any) payments from this policy, the amount you would need to contribute to receive enough income for expenses at age 90 and beyond would be fairly low.  Plus, your expenses at age 90 if you live that long will likely be fairly modest.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The Beauty of the US – Everyone Has an Equal Chance


I was thinking the other day about what it would be like to go out on your own, a few hundred dollars in your pocket, and try to make it in the world.  Thinking about trying to find a place to live, find a job, buy clothes, food, and other necessities.  One thought was that it would be difficult for someone who came from an impoverished background, with both parents on welfare because of medical conditions or lifestyle choices, to get a decent job because such an individual would not be able to get the education needed to move into better paying jobs.  It seemed like they would be at a great disadvantage to someone from an upper-class or middle-class background.

But then it occurred to me – those in the US whose parents are poor have an equal ability to pay for college, even at elite school, as those who come from wealthier backgrounds.  If anything, they are in better shape than the typical middle-class family.  How so?

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There is an enormous amount of educational welfare available, coming from both the Federal Government and the schools themselves, that really make the ability to pay for school equal for all, or even to the advantage of those from poor backgrounds.  A student whose parents make $150,000 per year will probably pay something like $25,000 per year to go to Duke University or Harvard.  If that same student’s parents also had a couple of million dollars in the bank, even if they made $80,000 per year instead of $150,000 per year in salary, they would probably pay most of all of the $45,000 per year it costs to attend Duke or Harvard, including room and board.

Someone whose parents make nothing and have nothing saved up would pay nothing to go to those same schools.  They could go to a community college, a state school, or even an elite private university and pay nothing to do so!  Between the reductions or eliminations in tuition that these schools provide to students who show financial need and the grants given out by the federal government, which do not need to be paid back, students from poor backgrounds see little if any cost for going to college.  So there is really no financial reason for a student not being able to leave home and gain the education needed to make very good money in the US even if his/her parents didn’t make more than $10,000 per year their whole lives.

So the first lesson for those reading this article from poor backgrounds:

There is no financial reason that you cannot learn the skills to increase your income.

Now it is totally different for someone whose parents do make decent money, but are not willing to support their children financially for college.  In this case, the schools and the federal government will look at your parent’s wealth and income and expect them to support a portion of your educational costs based on what they could fund if they wanted to, even if they choose not to do so.  This is really unfortunate since there are parents out there who do cut their children off when they leave home even if the schools and the government expect them to provide support.  It is understandable from the school’s prospective, however, since if colleges just took your word for it, virtually everyone would not give any money to their children for college so that they could go for free.  (Boggles the mind to see that people who would never take charity for other things see nothing wrong with having others fund their children’s education when they could do so themselves, but apparently there’s no taboo when it comes to accepting college financial aid.)  So this is a lesson for parents of middle-class or upper-class background:

Your children will likely get little in terms of financial aid, regardless of whether or not you have saved up money for their college education, so start saving early and plan on footing at least part of the bill to keep them from being buried in student loans.

There are some ways out get out from under this cloud, including waiting until you are 23 or older to go to college, or getting married right out of high school.  Some of the other criteria for not needing to include your parent’s information on financial aid forms are listed here.  There are also a lot of scholarships out there that can help cover college costs that don’t require showing financial need.  These might be an option if you generally have good grades and have been involved in various activities to show you are well-rounded.

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Now, there are other factors that keep children from impoverished families from going to college and raising their income.  Many don’t have good grades while they are in grade and high school, which is understandable if they have no one at home pushing them at all, or even have a home life that makes it difficult for them to perform well in school.  But again, there are still ways to make a better life for yourself than a series of dead-end, low-pay jobs.

Community colleges:  If you are able make it into a community college, which again could be free for you if you come from a poor family background, you have another chance to change your destiny.  If you concentrate on your studies and get good grades at a community college, many universities would then accept you into their schools.  If you are fortunate enough to get in, spend at least two hours per week doing homework and studying for your classes for every credit hour you are taking.  For example, someone taking 12 hours should be doing 24 hours of work outside of class, for a total of 36 hours per week.  Also, go to office hours for help if you don’t understand something, and spend time getting to know your professors since you will need them for references when you apply to the university.

Trades:  Jobs in the trades pay a lot of money.  If you can do electrical work, plumbing, carpentry, computer repairs, and other similar jobs, you can make a lot more than you will working in retail or at a fast food job.  Many jobs in these areas are earned through experience with a professional in the industry.  If you are willing to be a good worker, showing up on time, being willing to work hard and get the job done, and are willing to learn all that you can while you are on the job, you can get a job with a trade professional and learn what you need to eventually do work on your own.

A final issue for those from poor backgrounds is that their families may continue to drag them down.  Someone whose parents have serious drug or health issues may feel an obligation to take care of siblings still in the home or their parents after they leave the house.  Realize, however, that you can’t save someone from drowning if you yourself are barely keeping your head above water.  It can be better for you and for them if you work to get yourself on firm financial footing first and then help where possible instead of trying to support siblings and parents by working a low-pay job and giving them what you can.  You might also be preventing them from getting welfare because you cause the income of their household to be too high to qualify for food stamps and housing assistance.

While it is difficult, the best option may be to cut financial ties temporally and concentrate on getting through school and raising your income, and then helping them out.  Encouraging your siblings to do what they can, such as getting a job while still in high school and/or working hard at school to get the grades needed to qualify for college is also better than trying to support a family on a minimum wage salary.  Two, three, or four people can do more than a single person can do alone.  Remember that anyone who has health has substantial wealth, even if they have no money in their bank accounts.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to Start Out on Your Own


My son, who is a junior in high school, asked me tonight if I could talk to a friend of his who was a senior and who was going to be leaving his house soon and start out on his own.  His friend didn’t know anything about personal finance and wasn’t sure how to get started.  My son wondered if I could give him some advice on money management and how to get set-up in the adult world.

That got me thinking.  Hopefully most children have some sort of help with the transition.  Maybe their parents help them get into their first apartment and then they start to pay their rent from a job.  Maybe they go off to college, which their parents help finance, and then they get a job before leaving school, or come back home for a month or two while they look for a job after college.

But what if you were a couple of months away from graduating high school, and your parents just said that once you graduate, you were on your own?  You just needed to leave home, maybe graduation night, and do whatever you could?  How would you prepare, and what would you do?

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Hopefully you would have a little time.  Let’s say that you had three months to prepare.  Here are the things that I would do:

1.Look at the basics:  Food, shelter, clothing.

To survive, you would need to figure out how you could acquire the basics.  How would you get money for food, shelter, and clothing?  Food for one person would probably be about $200 per month if you planned to eat at home, cook your meals from basic ingredients, and rarely if ever eat out.  Shelter could be somewhere between $200 and $400 per month, depending on where you live, if you did things like rent with a roommate, rent a room in a house, or look for other ways to save money.  You therefore would need to make somewhere in the vicinity of $10,000 – $12,000 per year to pay for the bare necessities for yourself (no children here).

You might be able to get a job that includes shelter (and maybe even food) such as a nanny or live-in housekeeper.  You might also be able to cut your rent by helping your landlord take care of the place by helping with yard care and maintenance.  A little creativity goes a long way when you’re scraping by at the start of life.

2. Think about work.

To gain the money needed for food, shelter, and clothing, you would need to have a job.  To just cover your basic expenses, you really could make it with a full-time minimum wage job at the start.  While you might start out as a fairly basic job, you should use the first job (and the jobs after that until you land your dream job) to learn skills that will help you get a better job.  If you work in a fast food restaurant, use it to learn things like how a business runs, how to please customers, and how to deal with coworkers.  You should also be looking for whatever training your employer can provide since the more skills you have, the more money you can make.

3.  Save up a baby emergency fund.

You probably won’t be able to gather up a full emergency fund of $9,000-$12,000 with your first job, but at least work hard to save up a baby emergency fund of $1,000 or so.  That money will help with some things like a car repair, a short job loss, or a minor illness.  Ideally you should save this money up before you even leave the house.  If you can’t, save as much as you can from your job (and maybe a second job) to get there as soon as you can.

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.4.  Figure out college or a trade school.

Even if you don’t have help from parents, you should look at college or training in a trade.  Luckily, if your parents do not make a lot of money, you will probably be able to go to school for free or nearly free through grants and financial aid.  This might involve a work-study program, but there is nothing wrong with working part-time in the school cafeteria in exchange for thousands of dollars in tuition being waved.  If your parents do make a lot of money, but simply cut you off, it will be a bit more difficult since the schools may still expect you to be able to get help with tuition from your parents.  Using community colleges, that cost a lot less, for the first couple of years and then transferring to a university to complete the degree might be a good way to keep costs down.

Also, if you’d rather work with your hands than sit at a keyboard all day, many trades pay as well or better than jobs for those with college degrees.  Electricians and plumbers can do very well, especially if you eventually start your own business, as do technicians, nurses aides, and other jobs that require an apprenticeship or a couple of years at a trade school.

5.  Move your way up the ladder.

College is one way to possibly increase your pay, but it is not the only way.  You make more money when you become more valuable and are able to serve more people.  If you have a special skill, are able to lead people, or are able to manage large projects, you can make more money.  Always be looking for ways to get additional training and experience through your work and other opportunities that present themselves.  Also always be looking for the next opportunity, either within your business or outside.

Realize that volunteer work can give you opportunities to learn new skills  You might not be able to get to lead a large project at work, but you’ll probably be able to organize charitable events such as food drives and can-ups since few people are wiling to step forward to do so.  You can also meet people you might not otherwise.  Some of the best people volunteer, including community leaders and small business owners who could be your net boss.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.