Monday, August 15, 2016

Annuity Instant Wealth

We have a 3-year-old $25,000 delayed pay annuity with State Farm Insurance that has riders. Now that I have figured out how annuities work, is it still a good deal?

I am using the mathematical model I created that seems to produce the same results found in annuity marketing materials. It also fits the one we are betting the house money on from Guardian Life.

So first we pay $25,000 to the company. It is no longer our money. A delayed pay annuity has two parts: First savings and second monthly payments. The pot of money put into the savings remains there (green, Chart 27). The pot of money annuitized (divided into equal monthly payments) is reduced by 1/10 each year (brown siding).

The annuitized pot contains, on average, 1/2 as much as the savings pot, therefore the interest Is also half as much; the brown line rises half as much above the pot at the start of the contract as the green line rises above the pot at the end of the contract.

The instant we sign the contract the annuity calculator turns that sum of $25,000 into $29,308!!! We have made (been assigned) $4,308 (assuming 3% interest per year). The company must pay us the total of $25,000 + $4,308 in interest in uniform payments for 10 years (Chart 28). It is that simple.

The company can keep this promise if it earns 3% (plus operating expenses) on the balance in our contract (brown line, Charts 28 and 29). In return for using the money we gamble on the company, it promises to perform the useful service of uniform monthly payments. This is in contrast to cashing in CDs with 3-4 year terms; that have a 1/2-year to a full year interest penalty.

The down side is that an annuity requires making a 10-year bet instead of 1-5 year bets on CDs. The up side is that an annuity averages out (smoothes out) the bumps in financial markets.

The extended time of 10 years also produces a higher amount of money with the same rate of interest in the savings mode of the delayed payment annuity. It promises $8,598 interest over 10 years at 3% rate in the savings mode (just like a CD). During the first five years it earns $3,982 and in the second five years, $4,606; a difference of $624. Two sequential CDs would come up short $624 as well as be subject to interest penalties if the money were needed earlier than the maturity date.

CDs and the savings mode of the delayed pay annuity add interest each year to the original $25,000 increasing pot of money. The annuitized mode of the annuity adds interest money to the decreasing pot. Uniform monthly payments cut the pot in half on which to earn interest. The result is 3% savings earns $8,598 and the annuity payments contain $4,299 (which is 1/2 of $8598 = $4,299).

So, if I let the savings mode run the full 10 years I will have $33,598 to annuitize. That turns it into a promise to pay worth $49,387 payable at $3,939 per year or  $328/mo. I will get my last payment at age 102 (assuming a simple clean contract). As is, the for-life rider would actually use up the interest if we annuitized the contract. To get the full rate of return, at 3%, we must terminate the contract at 5-years (age 88). Also if one of us lands in a nursing home we can terminate the contract without penalty.

There are many ways to market CDs and annuities. My best guess at comparing them is to figure out the clean rate of return (no riders of any kind). You do not have to figure out how old you are now, your sex, drug (tobacco) addiction or when you will die. Then add (or accept) riders that seem worth the cost (or that can be avoided by taking action within the conditions in the contract).

Comparing CDs and Annuities

Calculator Passes (1 and 2)                                    3.00% Input     2.625% Input

Total Payout (monthly checks)        10 Years            $29,308            $28,750

Total Annuity Cost (one check)                                $25,000            $25.000

Total Interest Amount                     10 Years              $4,308              $3,750

Total Simple Interest Rate              10 Years               0.172                0.150

Annual Simple Interest Rate            1 Year                 0.017                0.015

Simple Interest Rate as %               1 Year                 1.72%               1.50%

Comparable to CD Rate                  1 Year                 3.45%               3.00%

In this example, the second pass through the calculator has reduced the payout by $558 ($29,308-$28,750) to yield a 1.50% return on the $25,000 contract. It takes two of these to match a 3.00% CD. A CD works on all of the initial pot rather than on just half, on average.

A clean annuity delivering half the amount of interest money as a CD is performing at the same rate of interest as the CD. Yet marketing stresses the amount of annuity money paid out rather than the rate of interest for easy comparison with CDs.

I now have a smart annuity calculator (Chart 30). On the first pass I enter a value that represents the rate that will generate the desired simple interest rate. I can copy that result to the right column. I can then tease the entry rate until I get the exact desired simple interest rate (1.50% that compares to a CD at 3.00%).

The final entry value (2.625%) is the value that when compounded 10 years yields the simple interest  rate of 1.50%. The company seems to have limited risk in doing this in a normal financial market as the interest earned creates a positive balance from the first year (purple, Chart 29). It also has the $25,000 pot that is easy to divide into 10 parts. It is only the interest that actually needs to be averaged out. 

There is still more to understand here about the interplay of compounded and simple interest and how it lowers the cost of providing the contract (using 2.625% rather than 3.000% money). It appears that the annuitant benefits on the way up (savings) and the company benefits on the way down (annuity). 

I again end with: If I am in error on any of this, please let me know. I have had one response to the Comparing CDs and Annuities table above: “In 8 years of doing this, I haven't had any client report back to me with such a thorough comparative rendering. It's so refreshing!”

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