Wednesday, August 3, 2016

A 5% Increased Monthly Payment Contract

This is becoming a story of a pastime I have had difficulty with most of my life (allergies and stale tobacco smoke shut down my math processor) but from which I have obtained much pleasure and happiness: gathering all the information I could, doing something else, and immediately jotting down the answer when it came. (I dug a seven-foot deep French drain around half of our house in Maryville waiting for software answers.) 

I have always been amazed how real world events can be captured in numbers and then manipulated, as they could never be in real life. And then looking between the numbers to find powerful predictive relationships I never knew existed. Here the source of questions is the annuity and related investments.

Understanding the current popularity of annuities opened a number of questions. That one can about double the interest rate by reinvesting the immediate monthly payments was proposed by a family member. Is this real or is it an illusion, like a perpetual motion engine?

I would need to know how the annuity really works to make such a comparison. Interest on money is a tricky thing. I was surprised to learn, on my second job after finishing Hamilton Commercial Collage, that the vice-president of the Nora Springs, Iowa, bank was making personal loans of $100 but only giving the person $90 with the payback at $10/week for 10 weeks. This is a 10% interest loan over 10 weeks. The average earned interest, 20% over 10 weeks, is collected before the actual use of the loan. This is marketing a 10% loan.

Up until now I too took a 5% annuity inflation rider as a 5% increase in payments each year, until the contract ended.  The [next to the] last post opened the door to a number of questions I need answers to before comparing the annuity payments to re-investing.

The relationships between the numbers for the 5% increase payment are shown in Chart 23. The payout (blue) gradually, ever so little, increases over the 20 years of the illustrated contract. The difference between the 5% increase payment and the no benefit rate (red) vary, as expected. The result is an accumulation (green) of money at the start of the annuity payout (positive difference) and a withdrawal (negative difference) toward the end of the contract period. The highest point is at the end of 12 years, not at 10 years, the halfway point. This makes sense as not all of this money is paid out.

The illustration contract purchaser put $10,000 in the pot, on a monthly basis ($100,000 total). [The full pot is $100,000 + $20,000 interest over 20 years = $120,000 or $120,000/12 = $10,000 monthly payment rate] 

The balance (purple) in the pot decreases with each monthly payment until the end of the contract when $579 is still there (Chart 24). 

I have considered the interest rate I put into my annuity calculator as the rate the company had to earn to make payments at that rate. Clearly that is not the case. The initial $10,000 provides the needed funds with a surplus of $579 ($579 x 12 = $6,945 contract total) in relation to no benefit payments (Chart 25 and enlarged in Chart 26).

The total $120,000 in the full pot minus a total payout of $113,055 = a loss of $6,945 to the owner of the contract in respect to a no benefit, fixed monthly payment, 20 year contract. The cost to the company of a no benefit contract ($20,000) is paid entirely by the company from the interest it earns from the money it invests, including from the illustrated contract.

I took a look at the results of feeding “interest” rates of 5, 6, 7, and 8% into the calculator with the first monthly payment of $250 (half of the no benefit $500 monthly payout). Why the correction for 5% increase payment was limited to 7.5% in expanding the payout rates in the illustration is not apparent.

This raised the question of how well the fixed annuity model for determining monthly payouts works for the increased payment rates from 1 to 5 percent in the illustration. The new question blanked out the above story (how I was proceeding and what significance it had). It was like the new question appearing on a move screen with all of what I was doing fading out in the background. Gone.

I needed to write up how I got to this point (again make sense of what I was doing). That was the prior post. This morning, 2 August, I seem to be over a three-week battle with stale tobacco smoke. My head seems clear again. My innards are not grinding and hurting.] [7:55 pm. Its not over yet. Supper was late.   :(]

So here is what I am left with on immediate annuities:

Guardian Life is rated in the top five companies by Barons in June 2015 for ten year certain annuities. An immediate annuity update shows the payout rates in July 2016 (Chart 27) for different length contracts. The longer the money must last, the lower the monthly payout. A 10-year contract makes sense for me at 85 years of age.

At the same time, the longer the contract, the higher the payout interest rate (Chart 28). The longer the contract, the greater the effect of a change in dollar and interest rates, and the greater there will be a change during the contract that I cannot respond to beyond the fixed monthly payments.

A change of $10 in the payout is about the same as a change of 0.1% in the rate of interest (Chart 29). A small change makes a big difference only over many years or with interest rates higher than 1%. 

A time period certain annuity is really a long term CD with a periodic return of principal and interest, if no other conditions or riders are charged, such as life insurance on for-life monthly payments. 

"You will never out live your money" is popular and is not free as it includes life insurance. You are now gambling three ways: picking a wining contract, out living your average life expectancy and working with a well positioned financial adviser who is worth what is charged in this ultra-low interest era.

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