Let’s have a little discussion about annuities. I think it’s appropriate because I’ve seen a lot of articles about these things over the last few years.
The reason for the renewed interest is because people are scared. When people are scared they’re vulnerable and when they’re vulnerable they make mistakes. I think annuities right now are a mistake. I say now because in the past there were situations where they made sense, this may also be the case in the future. But right now they’re a suckers bet.
To begin let’s make sure you understand what an annuity is. An annuity is an arrangement whereby you agree to hand over a lump sum to an insurance company in exchange for an income payable for either a fixed term (say 20 years) or over the balance of your lifetime.
The benefit the insurance industry is trying to sell is that you can’t out live your income if you purchase a life annuity. That’s true but as is the case with all investments, there are risks that these promoters usually fail to talk about. In my opinion, the biggest risk with annuities right now is inflation.
Let me ask a question. Would you be willing to buy a 30 year government of Canada Bond at its going rate of 3.16%. In other words would you agree to lock in your money for the next 30 years at 3.16%? I hope the answer would be NO!
Basically, when you buy a life annuity, you’re locking in the interest rate for the rest of your life at the rates in effect at the time you buy it. Back in 1981 life annuity rates were about 17% because that’s what the long term interest rates were at that time. You can imagine how well the people did who bought life annuities at that time. But today the tables are turned. The rates today are at historical lows, the rates back then were at historical highs.
I said buying one right now would be a suckers bet. I say this because if you look at “probabilities” which direction do you believe interest rates are most likely to go over the next thirty years? I think everyone would agree that rates will “probably” go up because they have little opportunity to go down. If interest rates go up so will inflation.
I wanted to see what it would look like if you took $250,000 from a 65 year old woman and bought a life annuity with guaranteed payments for 10 years (what this means is that the payments would be guaranteed for life except that if she happened to die in the first 10 years the insurance company would pay out until the end of the 10th year). The monthly payment was $1,189.09. Now if you look on the surface you’ll see that the payment would be equivalent to an annual rate of 5.7%. That looks really good but you have to know that the payment is fixed at $1,189.09 for the rest of your life. How would you like to be on a fixed income for the rest of your life?
If you’re 65 and female your life expectancy is about 30 years. In 30 years what do you think the purchasing power of your $1,189.09 is going to be if inflation averages 3% per year? The answer is $491.59. Doesn’t look so good any more does it?
An alternative is to buy an indexed annuity. That would give you $791.17/month to start and would increase each year by 3%. $791.17 per month is equal to an annual rate of 3.8%. That doesn’t look so hot either and in both cases when you die after the 10 years the insurance company keeps the rest of your money.
Here’s a simple alternative. Buy $250,000 of Royal Bank of Canada common shares. They pay about a 4% dividend and have increased both in value and increased their dividends numerous times over the last 60 years. Just a thought!