Annuities That Work

by Mr. Cheap

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I love the IDEA of annuities. You trade cash upfront for a guaranteed income stream for life. The Derek Foster approach to investing is along the same lines (although his approach hopes for regular dividend increases in addition to a steady income stream).

The problems I see with annuities are:

  • You have to be older to collect the income stream. You can purchase one when you’re young, but it doesn’t pay out until you’re much older
  • They pay out a very meager return (quite a bit of the returns from the investment go to pay whoever sold the annuity and the company that manages it)

The vehicle I’d like to set up would be something like a university endowment, where the money is conservatively managed and an inflation adjusted return is guaranteed to the purchaser for life. The return should actually be quite decent, since you’ll have a large pool of money for the long term, have new money coming in every time someone purchases a new annuity and will get to stop paying out to people when they die (at which point their funds become available for increased investment returns or to payout still living subscribers). An actuary would be needed to figure out the price and returns (factoring in purchaser life expectancies and whatnot), but I suspect for a very young person, more than 7% could be offered (since 7% is the expected long-term market return and you won’t have to keep paying out to all your purchasers forever – you’re guaranteed to be able to stop paying out to a certain number each year).

Since the purchaser is sacrificing liquidity (they can’t ask for a return of their initial purchase price) and are forfeiting this money and the income stream when they die, the fund should be able to offer an ongoing high return.

Consider these annuity returns. They’re giving a 7.7% nominal return to a 65 year old male. Since the male is expected to live for about 14-18 more years, the insurance company is making BANK! These are fixed payments, so just from the expected market performance the company should be making a nominal 2.3% return on the purchaser’s $100K. After earning income from HIS money for 16 years or so, they get to keep it all! Pretty sweet payment for whatever small risk they’re taking (yes, they may pay out to someone in the middle of a bear market, but they also would have been collecting extra during previous and subsequent bulls). I think they could easily afford to offer a 7.7% nominal return to a NEWBORN BOY, let alone a 65 year old! (although I have no idea why a newborn boy would need it).

If you invested the money YOURSELF, and withdrew $650 / month, you’d expect to have more than $100K left when you died! With the annuity there’s nothing left after you died. Even with a 2% nominal return (you could easily get this from GICs/CDs) you’d expect it to last you about 15 years.

This would be ideal for someone who needs a guaranteed income for life (someone worried about running out of money), but doesn’t need to leave behind an inheritance (sorry kids!).

Obviously there’d be no transfer to a surviving spouse (unless this was chosen as a purchase option and a correspondingly lower payout was offered), and an income stream would be more expensive the younger the purchaser is (i.e. a 20 year old might be able to purchase an inflation adjusted stream of $100 / month for $17,142 while a 70 year old might be able to purchase the same stream for half the price).

I know this is VERY similar to annuities that are already offered, but the core of this idea is to have very cheap management (do something like the couch potato portfolio so that your management fees would be minuscule – along the lines of an index fund) and no sales or marketing budget (let the smart customers find out about it and come to you).

Legislation would probably be the tough part of setting something like this up, as you’d be an insurance company and would have to conform to all the legal requirements insurance companies do to prove you can cover your policy holders (I have no idea how this works).

I’d call the product “death insurance” since its the opposite of life insurance :-).

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{ 4 comments… read them below or add one }

1 Dividend Growth Investor

To me annuities always looked like a bond payment. My question is why can’t a person simply buy a bond yielding 5%-6% annually and withdraw the funds?
Another fixed income idea that is better than an annuity is invesitng in inflation protected securities.. Spend the coupon and let the principal grow with inflation.. That way you have some money left over when you pass your assets to your kids..

An even better idea is to invest in dividend growth stocks that will increase their dividend payments to you.. That way you will have an income stream that provides a nice inflation adjusted cash flow for you.. In addition you are much more likely to earn capital gains if you decide to sell sometime down the road..

2 Kyle

I would actually love to be able to invest in a university-endowment-type fund, but I have no need for the income guarantee. I just want to be able to diversify my portfolio the way the big boys can.

3 Four Pillars

This is a good idea for someone who is selling annuities.

On a different topic – I don’t think it’s necessarily a good idea for individuals to emulate endowment funds since they are two separate animals. An endowment fund has a forever timeline and always has money coming in and out. An individual has money coming into their portfolio for a long time and then only money leaving the portfolio for a long time.


4 Louis

Solution: Self-Directed Annuity

Why not a self-directed annuity, like a self directed RRSP? Why should I be deemed stupid in my retirement?

For conservative money management, one should never withdraw more than 3% of equity annually. However, an increase in capital would allow the investor to obtain a raise to offset inflation.
Such management could be assigned to an insurer, a mutual fund company or trust company for sytematic withdrawl of (3/12)% payable monthly.

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