The concept is simple: write a single check to an insurance company and receive monthly income for the rest of your life, even if you live to be 100. No more worries about market crashes, bursting bubbles, interest rate fluctuations, terrorist attacks, financial contagions, recessions, or even depressions. It sounds pretty appealing - just cash your monthly checks, play golf, travel, and enjoy your retirement years. Unfortunately, this fairy tale could not be further from the truth.
Fixed Immediate Life Annuities
Before exposing the many problems of annuities as an investment vehicle, let's look at a specific example of a fixed immediate life annuity. According to one of the many free annuity calculators on the Internet, if a single female retired at age 60 and paid an immediate payment of $100,000 to the insurance company, she would be entitled to receive a fixed payment of $474 each month for the rest of her life. If she received $474 per month, that would equate to $5,688 per year or 5.688% of her initial investment.
A return of 5.688% per year for life sounds pretty good in the current environment of low interest rates; what are we missing? I expect the insurance salesperson forgot to mention this, but the annual payment of $5,688 includes both principal and interest, exactly like the monthly mortgage on your home. We can even use a mortgage payment calculator to solve for the expected annual yield on the above fixed immediate life annuity.
The average life expectancy of a 60-year-old woman in the United States is currently 84.5 years. On average, a 60-year-old woman would expect to receive 294 monthly payments of $474 on her initial investment of $100,000. Based on the time value of money calculation, the resulting annual interest rate would be 2.87%, not 5.69%. That does not sound nearly as attractive and unfortunately it gets worse.
Why are the promised returns so low? Because interest rates are at or near historic lows. The rates of return offered by insurance companies on fixed immediate life annuities are a function of the current market environment and life expectancies. Annuity buyers often overlook the fact that their money must be invested by the insurance company to fund the promised payouts. When interest rates are low, payouts are low.
In addition, the insurance company must offer a below market rate to recover all of their fixed and variable costs, including the exorbitant commissions paid to annuity brokers or salespeople. The insurance company also builds in an attractive profit and an investment cushion, both of which further reduce the promised payout.
An annuity with a fixed payment of $474 per month does not sound like a high-risk investment, which is why so many unsuspecting retirees buy annuities. In fact, many investors purchase annuities in an attempt to eliminate risk. Ironically, investing in annuities has the opposite effect. Annuity investors forgo upside returns, but downside risk remains.
Remember, insurance companies receive the full premium for the annuity in advance and invest those assets in an effort to fund the promised payouts. If the insurance company's investments earn more than enough to meet the payouts, they keep the excess cash - all of it.
However, the insurance company's portfolio is subject to all of the risks that the annuity investor hoped to avoid: rising interest rates, defaults, derivatives exposure, market crashes, currency wars, hyper-inflation, etc. If the insurance company did not have sufficient funds to make the promised payouts, the annuity investor could lose everything. Would you ever hire an investment firm and offer to let it keep any excess returns above 2.87% per year, while you absorbed all the losses? Of course not, but annuity buyers do it every day.
The resulting profit and loss diagram for the fixed annuity looks very similar to the diagram in Figure 1 below. The horizontal or x-axis represents the value of the insurance company's investments. The vertical or y-axis represents the gain or loss to the annuity buyer.
If the value of the insurance company's investment portfolio exceeded the payout, the annuity buyer would receive her 2.87% per year. If the insurance company's investment portfolio were not sufficient to meet the required payout, the company would default and the annuity buyer would only recover a fraction of her original investment.
For those of you familiar with options, the diagram above is comparable to selling a naked put option. The seller of a naked put would receive a small premium in exchange for almost unlimited downside risk. If the annuity buyer's profit and loss diagram is similar to selling a naked put option, then the insurance company's profit and loss diagram is like buying or owning a put option.
The one sure way for the insurance company to increase the value of its implicit put option is to increase volatility, which means take more risk with your money. This is called moral hazard, the same moral hazard that induced large banks, brokerage firms, and insurance companies to take the highly-leveraged, reckless bets that precipitated the Great Recession of 2008.
While some state agencies do "guarantee" annuities, the loss limits are insufficient to provide a reasonable standard of living. A $100,000 loss limit would only be enough to guarantee a payment of $474 a month - well below the poverty line today and virtually worthless after 20+ years of inflation.
Fixed annuities are subject to surrender periods: the length of time the annuity investor must keep her funds with the insurance company. They vary, but surrender periods are typically from 10 to 15 years. Surrender charges decline over time, but can exceed 15%. As a result, even if the annuity investor were to perceive her funds were at risk, she would still not be able to liquidate her annuity - at least not without incurring substantial surrender costs.
Even if the annuity investor were fortunate enough to receive all of her promised payments in full, the price of food, clothing, housing, energy, healthcare, medication, and other essentials could climb much faster than the meager 2.87% rate promised to the annuity buyer. Inflation risk is potentially the single greatest threat to retirees and buying a fixed life annuity today would be analogous to investing in a very long-term fixed rate bond at the cyclical low in interest rates.
Central banks around the globe have been printing money at an unprecedented rate for the past five years; as a result, global equity and debt prices have been artificially inflated far above market-clearing levels. When market prices eventually correct, equity and debt returns could plummet and inflation could reach record levels. This worldwide epidemic of cheap money has exacerbated the risk and lowered the promised return of fixed life annuities.
Fixed life annuities offer low returns and are subject to high risk, both systematic and company specific. They are highly illiquid and offer no protection against inflation. Market risk has increased and we have witnessed two once-in-a-generation market implosions during an eight-year period. Maintaining flexibility in an investment portfolio is more important than ever and fixed life annuities do not play a role in that portfolio.
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