Outside the Box: How can I tell if an annuity is a good deal?

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Q: The annuity I just bought guarantees me 5% return for the next 10 years and 5% of the accumulation at that time (I’ll be 75) for life and if I die early my wife (73) gets the 5% for as long as she lives and if we both die before I’m 95, the payments continue to my kids. I understand how expensive the fees in some annuities can be but why should I care about the fees when I am getting guarantees in return?

A.: Expensive is not always bad, just as cheaper is not always better, but fees do matter. Ideally, what you get is worth what you pay. That’s the case for any purchase. Your example is a good one to illustrate the cost of guarantees.

Your contract does NOT guarantee a 5% return. It guarantees a 5% increase to an accumulation value that can ONLY be used if converted to a lifetime payment. That 5% payment is NOT a guaranteed return either. It is merely how the lifetime payment is calculated. The payment is 5% of that accumulation value.

To determine your return, look at the cash flows. Say someone promises you 3% interest and you hand them $100. They give you $3 back but then don’t pay you another penny. You would not say your deal paid you a 3% return, would you? No, you would say you lost 97%. Likewise, when looking at these annuity contracts, consider how much you give the insurance company and how much comes back.

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Let’s say you put in $100,000. Compounding at 5%, in 10 years the accumulation value is $162,900. Your payment begins at 5% of that or $8,144 a year for as long as you or your wife is alive with a minimum of 20 payments. This type of payout arrangement is a joint life, 20-year certain immediate annuity. There are other types of payout arrangements but the cashflow approach to determining the return still works for all of them.

Running an online search, $162,900 can buy a joint life 20-year certain immediate annuity for a couple at your age 75 and your wife’s age 73 that pays $10,572. If interest rates are higher when you turn 75, the payout will be even more but your payment from your annuity will not. You are essentially buying your payments now. Remember you can’t get your hands on the $162,900, only the actual balance of the investment. Due to the fees, the cash available balance is likely to be less than $162,900.

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What are the odds your investment will grow faster than 5%? Typically, the odds are poor because most contracts restrict how aggressive you can be and saddle the investment fund with fees usually over 3%. I’ve seen some fee schedules over 5%. To get an 8% growth rate, you would have to be aggressive and do well.

No problem being aggressive when you have a guarantee, right? Not exactly. Remember money invested versus money returned. Another way to look at it is that based on the same online search, it only costs about $125,508 to get a payment of $8,144 in the open market. $100,000 growing to $125,508 in 10 years is only a 2.3% compounding rate. That’s your true guaranteed return. 2.3% guaranteed over 10 years isn’t terrible but it hasn’t required a lot of risk to do better historically ether.

You also need to be careful that you truly want to turn your investment into the income stream in 10 years because you only get your guaranteed 2.3% if you start getting payments. If you remove any money before the payments begin, you usually do worse than if no withdrawals were made.

Many people find it more appealing to invest conservatively in a more accessible way with far lower fees and fewer contract restrictions and buy an annuity payment on the open market later if they still think they need guaranteed lifetime payments. For many the math works out well in their favor even after factoring in taxes if they are tax smart about how the portfolio is structured and managed.

If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.

Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.

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