My wife recently retired, and we faced, once again, a deluge of tempting things to do with her 401K and other retirement funds. Coincidentally, a friend asked me about a juicy annuity: he could cash in a company 401K plan worth $200,000 and get something like $1000 monthly, "forever!" "That's 6%!", he exclaimed. In fact, the world is beating a path to senior doors, all making similar pitches. For example, Barron's Magazine just listed the 100 "BEST" annuities in America. Leading the list of plain vanilla annuities are offerings from American National (5.8%, $966 monthly) and Guardian (5.79%, $964 monthly). There are endless variations, with survivor benefits, inflation adjustment, foot massage, etc. The moral? Be afraid, very afraid.
My first question to anyone interested in an annuity is whether he gets the difference between "return on principal" and "return of principal." At this, most people's eyes glaze over. They should reach for the Visine instead. In my friend's example, the 6% is a return ON principal, but there would never be a return OF principal. As Mark Twain learned to his great regret, the difference is crucial. The company is going to keep the original $200,000, no matter how long you live. If you live a VERY long time, the payments might make up for loss of principal, but like your virginity, the pristine annuity investment is gone forever.
There is a very simple way to test whether an annuity is a good idea. Pretend you're a bank yourself, "Sybaritic Seniors?". Assume some home-buyers come to you, hoping to borrow that self-same $200,000. Like any standard borrower, they expect to pay a fixed amount per month. After the final payment, in say 20 years (the average life expectancy of a 65 year old buying an annuity), they want to own the home free and clear, owing Sybaritic Seniors nothing at all. They ask you to set the monthly payment at $965. Doesn't this sound a whole lot like an annuity company seeking to borrow your $200,000 with a $965 monthly return?
Pull up any basic mortgage calculator. You will find that a $200,000 loan with a monthly payment of $965 over twenty years implies an interest rate of 1.5%! Would you, in your wildest dreams, ever lend that kind of money for that length of time for that tiny return? Wouldn't that just be ... stupid? All an annuity company (your bank's customer) would need to do to get rich is find an investment that would yield over 1.5% yearly, and pocket the difference. Gosh, where would they ever find that? Well, there are THOUSANDS of investment-rated bonds that yield over twice that 1.5%! Some would yield three times as much.
There's more bad news here. If your 401K or IRA was funded with pre-tax dollars (most are), then the annuity payout is taxable! At 25% (pretty common for average folks), your post-tax return plunges to $724, or 1.125%. Ouch. But wait, as in an infomercial, THERE'S MORE! Over the last 16 years, the average rate of inflation in the US has been 2.24%. That means, as in the above example, you are losing over two dollars to inflation for every post-tax dollar you receive. This is how an annuity can put you on a Friskies diet in a few years. Yum!
If I were in the annuity business, I would just find a few (thousand) anxious seniors, wave that tempting "6%" in their faces, actually pay off at the rate of 1.5%, and slurp the cream for the next couple of decades. With any luck, those lenders will do you the extra favor of dying early. In that case, you still have their money, but no longer owe a dime!
Now, let's pause a moment. The annuity is not, of course, actually a mortgage. The example above assumes a fixed-rate, fixed term mortgage (1.5%, 20 years). In real life, an annuitant might live much much longer. If she lives to 100, then total payments of $521,100 might look pretty good. But, remember that $200,000 of it was her money to start with. Even under this extreme scenario, the compounded rate of return over that 35 years is still a mere 2.77%! And don't forget the terrible news about income taxes and inflation.
Now do you understand why everybody and his brother is trying, frantically, to sell you an annuity? Taking the above example, it would make sense for the seller to hire a bunch of aggressive salesmen (call them financial advisors, if you like), and pay them 5 or 10 percent off the top. He's locked the suckers in for decades, so what's a little baksheesh among friends? He'll still get rich on the carry, they on the bribe.
In one of my very first posts (October 2010), I suggested the common-sense alternative to an annuity: a few carefully chosen BBB-rated bonds, coming due about the time you think you will ... come due (or later, of course). You can still find some of these yielding north of 6%, particularly energy issues. Yeah, they're considered risky and volatile, but in the bond world, that still means the great majority will pay off, in time and on time. Diversification would handle most of the risk. $200,000 invested in such bonds would return $1000 a month for twenty (or thirty, or forty) years. Then, when the bonds mature, you will still have the $200,000 you started with. Great for you, or your grateful heirs. And if you really need extra money in the meantime, you can always sell off some of the bonds. They trade on the open market, after all. Try asking your annuity provider for the same consideration!
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