Sunday, November 27, 2016

Managing CDs as an Annuity

Buying an immediate pay annuity that fixed the interest rate on current historically low rates for the next ten years bothered me. CDs can fix interest rates from one to five years and take advantage of rising interest rates.

Chart 31
Chart 31 shows the interest rates for five CDs worth $90,000. The other $10,000 is in the bank to pay current expenses out of a $100,000 pot; that annuities divide into ten parts plus the expected compound interest ($10,823 per year payments).

Chart 32
Chart 32 shows the interest earned by the CDs over a ten-year period corresponding to an annuity. I found the “2%” CDs actually earn an average rate of 0.82% over 10 years.  Over five years, that would be an average rate of 1.64%.

Chart 33
Chart 33 ladders the five-year CDs. It produces the same total interest as not laddering. There is a shift in the time the interest is earned. The jumbo CD earned 80% of the interest in the first five years; the laddered CD earned 75% in the first five years. Therefore you ladder when expecting higher interest rates and start with a jumbo CD when expecting lower interest rates.

If I were to reinvest the interest at twice the 2% rate rather than spend it, the jumbo CD scheme would yield $71 more over laddering for the ten-year period. This is not practical but does show again, the earlier you invest the more you make.

You can always cash a CD. Annuities are binding contracts for their duration. Until this month, I did not know of any insurance company offering a free liquidity rider. It would let me take out part or all of the remaining funds in the pot. There is a catch. I will get the “discounted” value of those remaining funds.

Chart 34
After several emails and telephone calls I found out what this means. Chart 34 shows the compounded interest value of $100,000 in ten years ($108.230). The insurance company holding the annuity could discount that value (the Future Value) along the very same route (0.82%) that created it (blue line) IF it would settle for the same CD rate of return (1.64%). It will not do that nor tell me what the discount rate is until I ask to cash the annuity in. The rate will be set at that time.

[The CD rate of 1.64, on Chart 34, turns out to be 1.59 with an annuity. That 0.05% is the difference between the annuity compounding each month and my CD model set up on annual payments. The annuity is more efficient. It needs less start up money.]

Chart 35
I like Chart 35 better that Chart 34. Chart 35 shows the cost of either cashing in an annuity or selling the payments to an annuity buyer. The new free liquidity rider seems to follow the red line. Selling the payments seems to follow the green line. I would be more likely to sell a lottery win of $100,000 for $65,000 than an annuity.

Chart 36 shows what happens with CDs if half the Present Value (about $60,000), after the end of the fourth year, is withdrawn ($30,220). This is one year before the five-year CDs mature.

Chart 36
I cashed the jumbo CD with a penalty of $500. I bought five new $6,800 CDs of different durations to continue the annuity model. That left $30,220 to withdraw. The net cost $1,337. This same operation could have cost between $15,000 and $27,000 with an annuity (Chart 35) unless you are good at negotiating.

The financial market Is very competitive. The stock market is very unpredictable on the short term, but is predictable on the long term. I see little difference between immediate pay annuities and CDs under stable conditions and there is absolutely no need to cash in or sell an annuity. Buy an annuity before interest rates fall and enjoy a steady cash flow. Buy CDs when interest rates are expected to rise and you manage the CDs.

We bought our annuity with the house sale money at a low point in the market. It covers my wife’s medical bills for ten years when added to my Missouri state pension and social security. The cost of residential care may remain fairly stable with the decrease in the number of people turning that age in future years.

Again, if there is any question about this post, please comment or send me an email.

No comments:

Post a Comment