Why You Shouldn't Annuitize

As more companies do away with their pension programs, the insurance industry and the media are heavily promoting the use of immediate annuities to provide a dependable income stream during your retirement. But is that in your best interest? Normally, I say it is not. Read on to find out why.

An immediate annuity is one where you pay an insurance company a lump sum in return for a stream of income. You can decide if the income stream is guaranteed for a certain number of years (period certain), for a set number of years or your lifetime—whichever is greater; and whether your spouse should receive benefits for his/her lifetime after your death. Since you can receive a set payment for life and can also provide for your spouse after your death, this is seen as a ‘perfect’ pension replacement. There are four main reasons that I don’t advise this.

First, when you buy an immediate annuity you exchange a lump sum for a series of monthly payments. The lump sum is gone…forever. At that point your return is dependent on how long you and/or your spouse live (unless you chose period certain). If you live longer than the life insurance company expects then you get a higher overall return on your investment. If you die before then your return drops considerably.

For instance, Jack and Jill are both 62 and buy a joint life annuity for $250,000. In return, they’ll receive $1468 every month for the rest of their lives, regardless of who dies first. After the remaining spouse dies, that’s it. Nothing goes to your children.

Assuming their joint life expectancy is 85 years old, the internal rate of return on the annuity is about 4.6%. If they both die at 75 years old their average annual rate of return is negative 1.3%. If at least one of them lives to age 95 then the return on the investment was 6.1%. So your expected return is 4.6%, but your actual return may be more or less.

That illustrates another reason that I don’t think people should annuitize—all they are doing the first so many years is getting back THEIR money. Picture putting that same $250,000 under your mattress. Then each month you reach in and pull out $1468. You wouldn’t run out of money until 14 years later! That’s if you aren’t earning interest on it.

If you just put the money in a money market earning 3% you could keep using it until age 80. Let’s say interest rates go up (they will at some point) and a money market account pays 4.75%. Use one of those (or buy a 30-year Treasury bond) and you would cover the payments until one of you reached 86.

There are other benefits of not annuitizing. If your situation changes and you want/need access to more than the $1468 a month, you have access to the remaining principal. If you die before the money runs out the remainder can go to your children. The return you receive isn’t based on how long you live but on how it is invested.

Over time, inflation is your greatest risk. Jack and Jill’s annuity payment does not increase for inflation each year. If it did, it would be much lower to start with. Doing it yourself allows you to increase your payments over time if needed and/or based on your return.

Obviously, I feel there are better ways to invest $250,000 than putting it in a money market or CD. Over a similar period of time, a well-managed, well-diversified portfolio of stocks, bonds and real estate should average 8% or more. If so, you can meet the same income payment, adjust it for inflation and possibly never even touch your principal. Even if you end up using some principal, the chances are much greater that there will be money leftover for your heirs.

Some would rather let an insurance company bare the risks for them. There are risks to doing it yourself: interest rate risk, undisciplined spending, market risk, etc. But these are easily mitigated in a well-managed portfolio, and are far outweighed by your ability to earn a higher return while maintaining access and control of your money.

In addition to being a weekly columnist and Certified Financial Planning Practitioner, Mr. Voudrie provides personal, private money management services to clients nationwide. Goto www.guardingyourwealth.com for additional articles on this and other topics including investing and estate planning.

Tug of War

Tug of War

A novice investor recently asked me, “Why don’t you just buy what’s going up and sell what’s going down?” If it were only that easy, we’d all be millionaires! Read on to learn a simple analogy that seeks to explain the underlying forces that move the markets.

Think of investing in the stock markets as a game of tug of war. We all remember playing this game in gym class, with people pulling on either end of a rope, with a flag tied in the middle. The goal is to get the flag to your side as quickly as possible, and of course, to embarrass the other side by your superior display of strength. Of course, it didn’t always work out that way and I have been on the side of the falling team more than once!

This is how investing works in the stock markets. We often think that the value of a stock is based on the company behind it, but that is only partly true. Think of the company as the rope in a game of tug of war. It’s not just the quality of the rope that will decide which team wins, it’s the players competing on each side.

On one side of a ‘stock’ rope, you have investors who believe the stock is going up in price. On the other side is another group of investors equally convinced the stock price will go down. The side that puts up the most money will determine the direction of the stock price.

Unlike in real tug of war, the players in the stock market can change the amount they have invested and even the side they are on at any time. Some players might change several times in a day. Others might stay on one side for years.

This switching of sides is what results in huge swings in the stock price. If one side of the rope becomes overloaded, then they have the power to quickly pull the rope their way. If you have a lot of people and money on one side it’s not going to be much of a contest.

In the real game of tug of war, the game is won once the flag moves a set distance. Then both sides quite and move on. The stock market tug of war is much more fluid. Players can come and go. Some might quickly take their profit or cut their loss short. Others may wait until it looks like one side has won before joining the game on the opposite side.

Moreover, each player may have a different strategy that determines what side they play on—or whether they play at all. Some focus on the quality of the company (the rope). Others look at the statistics of what’s happened in that tug of war in the past. And there are some that just seem to walk up and pick a side without any rhyme or reason.

Outside events also play a role in the quality of the rope and the decisions of the players. There might be a hurricane affecting the oil supply. The expected outcome of an election could impact regulation. Housing prices can go up or down.

The decisions made by professional players have a much greater impact on the outcome of the game than do those of individual investors. That’s because they have a lot more money to invest. If all the professional investors switch to the same side, the individuals on the other side are going to get embarrassed!

Looking at a single game of tug of war allows us to get a general understanding of the underlying dynamics involved in the movement of the price of a stock. The movement of a market or a market index is really the sum of all the underlying battles taking place. The S&P 500 index represents the result of the tug of war occurring in 500 specific companies. The Dow Jones Industrial Average represents 30 select companies.

Successful investing isn’t solely about choosing which rope, but also choosing the right side. And it’s vital that you take into account what the other players are or will do. You won’t always get it right (nor should you expect to), but understanding why markets move will help you make more logical and informed investment decisions.

Mr. Voudrie is a Certified Financial Planning Practitioner and provides personal, private money management services to clients nationwide. Find out more at www.guardingyourwealth.com.