There is an oversight– if not outright mistake – commonly made by prospective annuity buyers and in this case seldom spotlighted: Insufficient focus on how much monthly income they need or want.
Prospective annuity buyers are notorious for the mistakes they make during the shopping process. They often don’t take enough time to consider which type of annuity best fits their particular needs and how it meshes with the rest of their portfolio. They don’t visit enough brokers or review enough products. They give insufficient thought to the downside of locking up their money in long surrender charge periods.
An additional oversight – if not outright mistake – commonly made by prospective annuity buyers and seldom spotlighted is too little focus on how much monthly income they need or want. Instead, they care mostly about how much they get monthly or annually and perhaps how much income they might receive in total if they live long enough.
Why is this a problem? It boils down to one word – inflation, a huge issue that resurfaced in 2021 for the first time in more than a decade. Payments from lifetime income annuities or plain vanilla annuities are rarely adjusted for rising prices. Annuity payments in future years will have less buying power – often a lot less – and must be taken into account.
“Many annuity shoppers, unfortunately, are like deer frozen in the headlights,” says Derek Stamos, a financial advisor at Somerset Wealth Strategies. “They’re looking at the total amount of income they may receive. What they are not looking at is the erosive effect of inflation over time. That is a significant mistake.”
You can buy a cost-of-living provision in many lifetime income annuities, but it seldom makes financial sense.
What, then, to do? Focus mostly on how much you need a month, and then, if you’re conservative, purchase an income annuity accordingly. Don’t buy a fatter annuity than necessary and make sure the investment is comfortably less than half of your financial assets. (Investors are always cautioned not to put more than half of their financial assets in annuities because of their lack of liquidity). So you have money to spare to invest elsewhere. Later, when you are older, you also would be able to buy another annuity offering a better deal, depending on how much could still prudently be invested in annuities. This is because pricing, in part, is based on age.
You often get the most bang for your buck in monthly payments if you buy a single premium immediate annuity. Say, for example, you’re a 60-year-old single man with $500,000 to invest and want to receive $500 a month for the rest of your life. That will typically cost you about $106,000, including return of unpaid principal to a beneficiary in the event of death.
This strategy frees up $394,000 for yet other investments.
If this man wants to buy an additional lifetime income guarantee for $500 a month 10 years down the road it would cost him less — $89,500 – again, because he is older.
Meanwhile, of course, he can invest his remaining funds outside of annuities.
If he wants to play it safe and stick with bonds, he should wait a while and see how much more they are yielding in the current inflationary environment. Say that long-time bond yields move up to 3 percent – higher than they are for now but reasonable by historic standards. That $394,000 could be worth more than $529,000 in 10 years, depending on the timetable of rising rates. If interest rates kicked up to 4 percent, it would be worth more than $583,000.
Conversely, our man could – but definitely should not – buy a single-premium immediate annuity with a COLA (cost-of-living adjustment). If he paid extra for a 1 percent COLA, which is extremely low, that aforementioned $500 a month would be reduced to $447 a month. If he bought a more typical 2 percent COLA, his monthly income would plummet to $397 a month. If inflation continuously rose, it would take him years to get back to $500 a month.
Most people would agree that it makes little sense to take less money today, when they are younger and hopefully relatively healthy, to at least partially protect them from inflation in the future. By that point, they could be living a highly restrictive life in a nursing home.
Clearly, COLAs in a lifetime annuity make almost no sense. And given the vagaries of the economy and the ups and downs of inflation, neither is it advisable to buy a lifetime income annuity without seriously weighing the corrosive impact of inflation over time.
You can do other calculations or pursue other investment strategies. What counts is that you don’t ignore inflationary considerations. Savvy investors always take this into account.
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