Thursday, July 7, 2016

How long will the money last? - How long will we live?

I must now get ready to work with a financial advisor. The idea being marketed is to find a way to "never outlive your money".

It is easy to calculate the answer to how long the money will last: Take the total pot and divide by the rate of withdrawal: $500,000/$10,000/month = 50 months or 4.2 years.

We expect to live longer than that. We also do not have $500,000 cash in hand. We also do not know what future expenses may be.

If we go broke after 4 years and are not eligible for Medicaid, we must depend upon relatives to support us. That is not good planning.

Currently in Columbia, MO, just a residential care bill can exceed $10,000/month at all four full care sites!

If we add our SS, my tax free MO pension, and our minimum required distributions to the mix, $500,000 will last 3 more years or 7.2 years.

The financial advisor does not want to wait 7.2 years for all the money to be in the pot. He needs the money up front. And he needs to know how long we will live. This problem is covered by insurance that pools the risk. He can estimate our age at death from life expectancy tables.

If we expect to live longer than the average, we receive a longer, lower, monthly payout. If we expect to live shorter than the average, we receive a shorter, higher monthly payout. This of course is gambling.

To produce a marketable product, most annuities insure a minimum payout of 10 years to us or our beneficiaries, or until we die. We cannot outlive the payments but that does not insure that all our bills will be paid.

So, how long will my wife and I live? At 85, one prediction is 7 more years for me; the same time the money runs out. At 79, the same prediction for my wife would put her at 86 and me at 92, on average. That is being right half the time for living that long.

The financial advisor must now turn a fixed amount of money into a stream of payments for an uncertain amount of time. He must not lose the money. It is not government insured. He must make his salary or commission plus a return for his investors.

Further, he must match the average life expectancy with the average return he can get when investing the $500,000. He has several ways to win and to lose. 

Casinos always win by taking a percentage (such as 1 penny/dollar) from the total pool. Players only win if they are in the top half of the distribution of players. Long term on average always beats specific short term players over time. The same has been found to hold for hedge fund managers.

The financial advisor can then balances short term needs (a ten year, or more, payout) with long term investments (30 year bonds).

Now for the other side of the game. The highest payout is to gamble with no protection. (1) When we die, the monthly payments stop. The insurance company wins the rest of our pot.

(2) Next, when we die, the monthly payments stop but the remaining portion of the pot goes to our beneficiaries.

(3) When we die, monthly payments to our beneficiaries continue for a period of time (10 years seems to be popular for several reasons).

(4) Monthly payments continue past 10 years until we die. There are no payments to beneficiaries. We have won a portion of the insurance pooled pot. 

As I understand all of this, an annuity is then not an investment but an insurance contract (a gamble) based on the number of years we will live and the investment success of the insurance company.

Each level of protection requires insurance that costs more at each higher level. Age 85 seems to be the limit on getting that insurance.

The insurance company starts with no risk as we must put up the pot of $500,000. It also owns the money. CDs are ours and can be cashed in anytime (with a low penalty).

(I keep using $500,000 as it and a million dollars are popular reference points for immediate annuities. We actually have a delayed annuity of $25,000 with a 2% interest guarantee and  a current performance over 3%. That money equals 3 months in residential care.)

Is then an immediate annuity better than laddered long term CDs in the predicted 10 year financial market? Can the insurance company out perform CDs enough to pay the expenses of providing the annuity?

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