Lifetime Annuity or U.S. Bonds
By Bob Moeller
WEAC Member Benefits
November 2004
Financial
Planning Seminars
Achieving
Financial Independence
Given these times of very low interest rates, I am sometimes
asked if it makes sense to use some retirement investments to purchase
a lifetime payout annuity.
The benefit of this strategy is you lock in a guaranteed
fixed income for the rest of your or your spouse’s life. You don’t
have to worry about stock markets or bond markets or anything. You have
no risk of loss. Even one of the well-known financial columnists acknowledged
they might be worthwhile.
I disagree. So, I set out to mathematically test out an
alternative. The alternative had to be as safe as any insurance company.
You could not suffer any loss other than the cost of doing the deal
which you would know about in advance and agree to. You had to be well
assured of an income.
First, I created a test couple – male age 65 and
spouse age 55. I then contacted a company that searches for the best
annuity deals through their Web site www.webannuities.com. I was very
pleased with the service I got, and it was free. I asked for annuity
rates for both lifetimes with a 20-year minimum payout guarantee even
if both died before 20 years. The couple would invest $50,000, with
the monthly payout to start in 30 days.
The quotes ranged from $257 per month to $268 per month,
($3,216 per year) the highest being GE Capital Assurance, a well-rated
insurance company. Now remember, this monthly payment is guaranteed
for 20 years, or life, if that is longer. There will be no adjustments
for inflation, etc. If both spouses are dead after 20 years, the insurance
company keeps whatever is left. So, their cost for this annuity is $50,000.
Next, I looked in the Wall Street Journal to see what
this couple could buy in U.S. government agency bonds. These bonds have
at least the implied guarantee of the U.S. government and are thus rated
AAA, as high as you can get. Examples are the Tennessee Valley Authority
(TVA) or Federal National Mortgage (Fannie Mae). Are these safe? Absolutely.
I wished to duplicate the couple’s income, but not use up the
whole $50,000 to do it. So, I deliberately looked at high coupon bonds
selling at a premium, i.e. $1,000 bonds selling for more than $1,000
because they pay higher than normal interest.
For this example, I used TVA bonds paying 7.13% interest
on each $1,000 bond, but selling for $1,250 each. They mature in May
of 2030, and at that time the couple would get back $1,000 per bond.
That means if they buy it, they will get $71.30 each year on the bond,
but lose a part of the purchase price. They understand that loss and
can accept and plan for it. If they use the $50,000 to buy 40 bonds,
they will receive 40 times $71.30 each year or $2,852 per year. This
compares to the $3,216 they would have gotten on the annuity, or $364
per year less.
However, when all is said and done, after 26 years in
the annuity, assuming both spouses have died, there would be nothing
left. After 26 years in the bond, they would have received about $9,464
less in interest, but have $40,000 left of their original $50,000.
If they survive, the couple – at ages 91 and 81
– would have $40,000 in cash to pay for a much higher annuity.
If they die, their heirs would get the income and the bonds. Their total
cost? Not $50,000, but about $20,000.
I consider this far superior to an insurance company payout annuity,
based on the pure mathematics of it.
If you think this type of arrangement sounds attractive
and want to use money you have accumulated in your tax-sheltered annuity,
401k, or 457, the only way to do so is to transfer it to a self-directed
IRA, preferably with a discount broker. Of course, make sure you understand
any withdrawal penalties you have in your TSA.
Separately, I was curious about what kind of an interest
rate the insurance companies were probably crediting to an account as
they made the payouts. Since your lifetime is never certain, it is impossible
to tell from the life annuity, so I asked for details on a simple 10-year
payout. In other words, how much will $50,000 pay out for 10 years?
No lifetimes involved here. The answer – again dealing with six
top-quality companies – averaged around $490 per month for 10
years. This works out to around 3% a year, when 10-year treasury bonds
were paying around 4%. Granted, you get back your money beginning immediately.
Assuming an “average” time of five years, five-year treasuries
were paying about 3.8%.
In addition, the return on treasuries is exempt from Wisconsin
taxes while insurance company interest is not, further making treasuries
the more attractive alternative.
Posted October 26, 2004