Annuities are insurance policies that pay you a fixed income for the rest of your life. When you take out an annuity you are exchanging your capital (the investment) for income. In my opinion annuities are a really bad investment option for most people because life serves up surprises that annuities cannot take care of.
Most people will never have enough money to invest in a high-income annuity. Let’s play with some numbers using Bankrate’s Annuity Calculator.
Suppose you want a guaranteed income for 50 years starting at $3000 per month. Believe me, that is a LOT of money for someone receiving income from an annuity. Assuming the investments earn a modest 4% annually you’ll have to invest almost $800,000 just to pull out $3000/month for the rest of your life. Of course, in 50 years $3000 won’t buy nearly what it buys today.
If you just pull out $1500 a month you only need to invest about $389,000 to keep that money flowing for 50 years. Now, if you go with the numbers a typical financial adviser might give you, they’ll point out that the stock market should perform really well over the next 50 years. Let’s assume an average growth rate of 10%.
With a 10% growth rate on the principle you only need to invest about $179,000 in order to pull out $1500 a month for the next 50 years. That doesn’t sound too bad, does it? Hell, you can win that money on a scratch off lottery ticket — or pull it out of your 401(k).
But before you whip out the checkbook, take a reality check. First, even if you don’t experience any financial disasters in the next 50 years the value of your monthly stipend DECREASES. You’ll be scavenging for crumbs in the back of restaurants by the time your annuity is almost done. The insurance company is making all the profit off your investment. Their appreciation for you declines every month.
Second, most people WILL experience financial distress more than once over the next 50 years. If you tie up all your investments in an annuity then when the time comes you’ll have to pull your principle out of that to make ends meet. And not only does withdrawing principle shorten the lifespan of an annuity, it comes with a stiff penalty.
Yes, the government will take a cut of your withdrawal if you pull out too much money from an annuity in any given year. So you’ll have to take out even more than you need just to cover the penalty and your expenses. And then your monthly income either runs out sooner or declines (or both — it depends on how the contract is written).
Of course, it’s not all bad. The lifetime payout of our $179,000 investment will be $900,000. Over 50 years that’s about a 500% increase in value. That looks pretty big, right? But let’s take a look at how much that investment might actually grow over 50 years with a compound interest calculator from MoneyChimp.
Assuming 10% average growth (this is really aggressive) your future investment portfolio value could be $21,012,962.67 (compounding only once per year) or $26,021,216.27 (compounding 12 times per year) or $26,547,769.17 (compounding daily). So now how good does that $900,000 lifetime payoff look? The insurance company will make millions of dollars off your paltry $179,000. That’s hardly fair.
If we back off the interest rate to 4% then your investment only grows to $1,322,496.11 (compounded daily), but your lifetime payoff through the annuity is still only $900,000 — so when average growth rates are lower than projected it costs you more money up front to reach that fixed $900,000 lifetime payoff and the insurance company makes even more money.
Is there any situation where an annuity makes sense? Well, let’s say you inherit $1,000,000 (after taxes). It might make sense to put about $100,000 of that money into an annuity just to keep yourself from spending it right away. But you should then channel the monthly payments into some sort of investment account — you know what? I can’t see me ever buying an annuity. It just doesn’t add up. It costs too much.