Is there a calculator in the house?
The NYT ran an article on how nice young men are bilking retirees out of their money by selling them insurance products that they don’t need. Since there isn’t much in the way of hard numbers, it’s hard to know how many people have really been affected (Massachusetts is considering action against some of the insurers, though.) However, I’m amazed at the way some things are phrased:
Regulators say annuities that begin paying immediately are often sound investments for retirees. A 73-year-old customer of one popular annuity, for instance, is guaranteed to begin immediately receiving $252 a month for life, in exchange for a $30,000 payment. If the buyer lives more than 10 years, that income is greater than the original amount paid.
That’s actually wrong. Sure, 10 times 12 times $252 is $30240, which is greater than the initial $30,000 outlay, but if you factor in the discount rate (how much you could have made if you parked your money elsewhere), you’re deeply in the hole after ten years compared to just sticking the money in a high-intrest bank account. (See net present value )
Right now, you can open a risk-free FDIC-insured account that pays 5% annually. (HSBC, for instance, has such an account.) Maybe you think that the feds will rejigger the risk-free interest rate (currently a shade under 5%), so let’s be conservative and say that you expect a 3% absolutely risk-free rate of return (compounded yearly). If the best you could expect is 3%, that $252 monthly outflow is only worth about $26,600 discounted at a 3% annual rate. You’d have to live about 12 years for your $30,000 to be worth $30,000 in today’s dollars. If the interest rate were higher (say, today’s 5%), it would take you just under 14 years to reach that point.
The advantage of the annuity is that it provides insurance in case you run out of savings before you die. Suppose that you put your $30,000 in such an account and made $252 withdrawls every month. At 3% interest (compounded monthly), it would take a shade under 12 years to deplete your savings – during which time you still had the option of moving your money elsewhere (say, if you wanted to help your grandkids make a down payment on a house). Of course, if you lived much longer than those 12 years (5% interest buys you an extra year and a half or so), you’d be in trouble, which I suppose is the point of an annuity. If you had an investment that paid 11.25% or so, you could live without touching the principal – but it’s unlikely that you’ll get that risk-free.)
The whole business seems a bit macabre, but insurance companies can cover the costs of unusually long-lived holders by setting payouts properly. (That’s assuming that they can’t earn at least 11.25% on their invested income, which would mean they wouldn’t need to worry how long the annuity-holders lived.) One shouldn’t, however, pay an annuity to just one person unless you’ve set it up to profit no matter how long they live. Or you might end up like François Raffray:
Jeanne Louise Calment (February 21, 1875 August 4, 1997) reached the longest confirmed lifespan in history at 122 years and 164 days. Her lifespan has been thoroughly documented by scientific study; more records have been produced to verify her age than for any other case.
In 1965, aged 90, with no living heirs, Jeanne Calment signed a deal, common in France, to sell her condominium apartment en viager to lawyer François Raffray. Raffray, then aged 47, agreed to pay a monthly sum until she died, an agreement sometimes called a “reverse mortgage”. At the time of the deal the value of the apartment was equal to ten years of payments. Unfortunately for Raffray, not only did Calment survive more than thirty years, but Raffray died of cancer in December 1995, at the age of 77, leaving his widow to continue the payments.