Risks of Taking No Risk

We love certainty. Unknowns are frightening. This is why many retirees opt for the guarantees provided by immediate annuities. These seemingly simple products can guarantee an annual income for as long as you live. With guaranteed income streams currently being quoted in the 6 to 7% per year range, the returns sound impressive, but are they?

First, you will not be getting a 7% annual return on your money. You pay the insurance company a lump sum, and you don’t get it back. There are a number of variations on this theme, but these are lump sum payments that purchase nothing more than a guaranteed income stream for life (or a set period, or life plus a set period). 

Given the fact that insurance agents are trying to make a commissioned sale, it is unlikely you will ever learn the reality of these policies. Remember, any time you buy insurance, you are making a bet with the insurer. If they don’t win more than they lose, they don’t stay in business. That means that you are likely to be the loser, even when something is guaranteed.

Take the following simple hypothetical example:

• You: 66-year old man
• Average life expectancy: 17 years
• $1 million to invest
• Wants high degree of safety

Now let’s consider four options (odds of living to various ages in parenthesis - from Society of Actuaries Retirement Participant 2000 Table):

* hypothetical return figures for a 10% global equity - 90% short/intermediate bond portfolio from Dimensional Fund Advisors from 9/1/1984 through 8/21/14 after fund expenses and a 0.90% annual advisory fee

If you put the million dollars in a safe, mattress, or old coffee can; you could withdraw $65,000 per year, risk-free up until age 81. That’s actually pretty risky since you have a 60% chance of still being alive (and broke).

Go with very safe, laddered 5-year bank CDs (currently about 2% annual interest) and you could draw a $65,000 annual income until you are just past 83-years old. That’s almost exactly your average life expectancy.

So you can see, with the Immediate Annuity, if you die before your time, the insurance company won’t have to pay out any more than a bank would offer on CDs. In other words, they aren’t taking much risk or paying much money, to take sole possession of your million dollars (to invest any way they see fit).

How much could the insurance company make by investing your money in a very conservative portfolio? Take a look at the last two rows. These assume investing $1 million in a portfolio consisting of 10% globally diversified stocks and 90% in a high quality, low duration bonds since September 1, 1984. By any measure, this is considered a very safe portfolio.

Even after collecting $65,000 every year, the portfolio would have increased in value over any 5-year time frame, so no matter when you died, your estate would have always ended up with well over $1 million. Sure, there were years when you would have seen your portfolio slip in value a bit, but, over 30 years, it would never even gotten close to your initial $1 million investment.

So, you can take no risk and make, at best about 2% per year on your money (unless you outlive most of your peers - in which case you might make up to an average of 1% more) or take just a little risk and possibly have a portfolio worth over a million, no matter how long you last.