In today’s low interest rate environment, anything above a 2% return sounds pretty good, and if you can find something that “returns” a “guaranteed” 7.58%, that’s great, right?
I saw the title of this blog post in an ad for an immediate annuity. For those of you familiar with immediate annuities, you’ll know what care the ad’s author has taken to make sure the 7.58% “solution” sounds attractive (like a rate of return?) while not being shown, deceptively, as a “return”. The solution? Call it a “cash flow solution!”.
If 7.58% is not a rate of return, what is it? Well, it’s the percentage of the original principal that’s returned in each year. Interestingly enough, the advertisement shows 3 issue ages for annuity payments: 65, 70, and 75, and none of these has a “Cash Flow Solution” rate of 7.58%. The highest annual payment, for the 75 year old male, gives 7.49% of annual cash flow back. For a single premium of $100,000, the annual payment would be $7,490, or $624.17 per month.
It is actually impossible to tell an annuitant what the return rate will be on the lifetime annuity they are buying. The yield can only be determined retrospectively, once the annuitant has died. If the annuitant dies prematurely, the yield can be 0% (or even less if a return of premium option is not selected). If the annuitant lives a long time past their life expectancy, the yield can look terrific.
Let’s take the case of the 75 year old male. According to the Annuity 2000 table with annual improvements, the life expectancy of this annuitant is 13.9 years. If this 75 year old buys the advertised immediate annuity for $100,000, collects monthly payments for 14 years, then passes away, he will have collected a total of $104,860 in payments for an effective annual interest rate of less than 0.7%. As a matter of fact, he almost has to live to his life expectancy to simply recover his premium during his lifetime. (He will finally exceed $100,000 in received payments after 161 months, or 13.4 years.) If he lives 20 years (6 years beyond his life expectancy), the payments total $149,800 for a pretax return just under 4.4%. And this from a “7.49% Cash Flow Solution”.
It might surprise you to know that, according to the same mortality table, this annuitant has a 24% chance of living that 20 years. The probability isn’t negligible. Which is why I don’t hate immediate annuities. I recommend them in some cases, and believe they provide necessary insurance protection for some given longer lifespans. But I don’t find value in advertising what looks like a high rate when that rate is not a return. What is of value is that the annuitant can’t outlive this stream of income. Relating that income to a percentage rate gives a great story, but opens the door to misunderstanding, especially in this environment of low investment returns.