Publication: Investor's Notebook
GETTING YOUR 'MONEY'S WORTH' FROM LIFE ANNUITIES | |
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Investor's Insight - September 27, 2006
"A Digest of Investment Opinion From the
World's Leading Financial Advisers"
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GETTING YOUR 'MONEY'S WORTH' FROM LIFE ANNUITIES
by Scott Burns
Q: I am a retired American Airlines pilot. I have a lump
sum of $650,000 invested in a 60/40 portfolio of equities,
fixed income and cash. It is well-known that variable
annuities and indexed annuities are burdened with a lot
of fees. But what about immediate annuities?
I can get an immediate life annuity with about a 6.5 per-
cent return for the rest of our lives that will pay into
our estate if my wife and I die during the first 10 years.
I was thinking about purchasing one of these annuities
with my $670,000 and keeping my other fund of about
$650,000 in tax-free munis. I don't feel comfortable keep-
ing money in any stock fund. -- C.R.S., Dallas
A: That's an interesting idea. To pursue it, you'll need
to learn something about the life expectancy you and your
wife share, and the value of a life annuity in that context.
The reason only a small percentage of all people, including
those who own variable annuities, convert their savings
into a life annuity is often called the "money's worth"
problem.
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People fear that when they give up their principal for a
guaranteed lifetime monthly income, they won't get their
"money's worth" -- they'll receive far less in value than
they gave to the insurance company.
In fact, if you get a joint and survivor life annuity,
there is a high probability that you'll get your money's
worth and a reasonable deal. Assuming you are about 65,
you and your wife have a joint life expectancy of about
25 years. This means there is a 50 percent chance one of
you will still be alive at the end of that time.
If you were to lend the federal government $670,000 for
25 years, it would promise to pay you $3,839 a month for
the period, assuming a long-term interest rate of 4.8
percent. (This is about what the government pays in in-
terest for long-term bonds.) You'd be dealing with a
risk-free borrower, but if one of you happened to live
longer than 25 years, you'd have a problem.
If you visit the Web site www.immediateannuities.com
and ask for sample quotes on a $670,000 joint lifetime
income with 100 percent to the survivor, you'll find
the current monthly income would be about $3,855. If
you and your spouse die before your joint expectancy,
the insurance company makes a higher return. If you
and your spouse live longer than the expected 25 years,
the insurance company makes a lower return.
How this actually works out, of course, depends on
closer calculation than these back-of-the-envelope
figures.
Basically, you'll be getting a reasonable return on
your money, monthly checks, and the assurance that
you'll get those checks for life in exchange for
letting the insurance company invest the money to
make a higher return for its own account.
The weak link here is thinking about putting your
remaining money, $650,000, in tax-free bonds. To do
so is to virtually guarantee that your long-term
standard of living will decline because all of your
assets will have been committed to fixed income.
I suggest two alternatives. If you want to avoid all
risk, invest in Treasury Inflation-Protected Securities
(TIPS). This will provide an inflation-adjusted income
starting at about 2.3 percent a year of the portfolio
value. That is less than you would receive from a mun-
icipal bond portfolio, but it's a better credit risk.
If you are willing to take some risk, you could get a
dividend yield of about 4 percent from an income stock
portfolio with the dividends taxed at 15 percent rate.
That isn't tax-free, but it's close.
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Q: I recently read a book about major figures in the
development of economic game theory, "A Brief His-
tory of Economic Genius" by Paul Strathern. In the
book he says that Game Theory is a "minimax" approach.
It is an attempt to minimize your maximum losses. Since
the stock market trends upward over time, with dips
large and small in between, do you feel there is a port-
folio theory out there that would minimax?
-- A.R., San Antonio
A: Gaming and investment come together in mathematics in
a problem called "Gambler's Ruin" and, so far,
the jury is still out on whether it has a portfolio so-
lution. You can learn a lot more about this, without
having to see or understand a single equation, by reading
William Poundstone's "Fortune's Formula: The Untold
Story of the Scientific Betting System That Beat the
Casinos and Wall Street".
Every serious investor and financial planner would
benefit from reading this wonderful book. It connects
gambling, information theory, computers and mathematics
through amazing people like Claude Shannon (the father
of information theory) and Edward Thorp, the man who
programmed an MIT mainframe to search for a way to win
at blackjack (he later went on to play in investments).
The betting system came from a brilliant young Texan
from Corsicana named John Kelly Jr. who created the
"Kelly criterion," a tool for evaluating wagers
rooted in Shannon's information theory.
Is it a winning formula? The jury is still out. But
Nobel laureate Paul Samuelson has written that it doesn't
work.
You can discuss this issue or any other topic in the new
Investor's Insight forum. Check it out here...
Investor's Insight Forum
(Investor's Insight reflects the opinions of experts. It does
not recommend any specific investments, and no endorsement is
implied or should be inferred. For more information, contact
the individual firms cited).
COPYRIGHT 2006 UNIVERSAL PRESS SYNDICATE
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