Are Annuities a Good Investment?

I was recently served an ad on Facebook for an upcoming “FREE Exclusive Screening” of The Retirement Deception at a local theater. Given my interest in the FI/RE community, I started looking into it.

IMDB gives it a 9.3/10 with ten 10-star reviews and one 1-star review. The 10-star reviews provide glowing endorsements, while access to the content of the 1-star review is no longer available.

The YouTube trailer is emotionally charged and made me want to watch it. But free things make me suspicious. 🤨🤔🧐

Vimeo has the entire video and also contains the Premiere content where the producers give away free prizes and explain the scheme:

They sell a local annuity salesperson the exclusive right to screen their infomercial disguised as an authentic documentary for a mid-4-figure fee in their local geography. In return, they market the event (ostensibly through paid social media ads like the one I received) and provide this salesperson with the contact information of attendees and the opportunity to set up follow-up appointments to sell financial products after viewing their emotional and convincing “film”. That salesperson gets an opportunity to speak briefly at the screening positioning him/herself as the expert.

Watching a few interviews where they interviewed folks who had it “all figured out”, a pattern emerged: after getting duped into investing in the “evil stock market” and paying fees charged by unscrupulous “financial advisors”, they recognized the error of the ways and instead purchased a guaranteed cash flow for the rest of their lives! After watching scores of people tell their tales of being taken advantage of, you’ll likely be ready to exit your stock portfolio and shift all your money over to this fixed stream of money that the entire Wall Street community has ostensibly been trying to keep from you.

Except they’re not. Annuities are well-known, long-term contracts with an insurance company. In exchange for a large upfront premium, they provide guaranteed monthly payments for the rest of your life. You can choose to have payments begin immediately, or you can defer them to begin at a later time. The former is more expensive than the latter.

The irony in the way they villainize the stock market and the commissions charged by financial advisors is that the annuity salesperson is officially known as a licensed insurance producer and will receive a commission from the insurance company from whom you’re purchasing the annuity in the range of 1-10%. Further compounding the irony, once the insurance company has your premium, they’ll invest it—usually in the stock market. Warren Buffett owns the insurance company GEICO as well as a massive reinsurance business and several other carriers. He uses the float—the premiums they take in upfront and will have to use to pay out claims in the future—to invest in the stock market. So his cost of capital is effectively 0%. All good insurance companies put their float to work instead of allowing it to languish.

Insurance companies are in the business of being assigned risks that others don’t want to bear in exchange for a fee called a premium. They pool these risks by calculating estimated payouts and adjusting premiums to not only cover claims and operational expenses but also to ensure sufficient profitability for the insurance company and its shareholders. Thus, while an annuity offers protection against market volatility, it doesn’t eliminate that risk. You’re merely paying the insurance company to assume that risk on your behalf—plus all their other expenses like paying the salesperson their commission.

I was curious about what kind of “return” one might expect to receive from an annuity, so I went to the number one sponsored ranking from Google to a company called Blueprint Income. I provided:

• my date of birth
• my gender
• a premium of $100k
• my desire to start monthly payments immediately

They spit out a ranking that showed their offer as well as the quotes from 12 other companies. No surprise that theirs was at the top and would provide me with $457.61/month or $5,491.32/year.

The next piece of information I needed was my expected death date, so I went over to my favorite morbid website the Social Security Life Expectancy Calculator. Based on my current age and gender, I’m expected to expire at age 81.6. Armed with that information, I opened a trusty Excel workbook. I listed my current age in the first column, the time period starting with 0 in the second column, and my cash flow list in the third column starting with -100,000. The next row starts with me incrementing my age and time period by 1 and adding the annual cash received of $5,491.32. I show my work at the end of this article.

Note: The Hermione Grangers of the Muggle World may point out my calculations aren’t exactly correct since I’m using the annual instead of monthly payments. 100% accuracy would require a larger spreadsheet and give me a monthly return instead of an annual return which I’d then have to convert. Because it wouldn’t substantially change the percentage nor my conclusions, I decided to KISS.

I continue this process until I hit 82 years old which is 45 years from now—I eat well and exercise, so hopefully, I can eke out an extra 0.4 years beyond the SSA’s prediction to make my math easier. If you think that the payments to me of $247,109.40 compared to my $100k premium is a lucrative deal, I’d counter by reminding you of the time value of money. We need to calculate the Internal Rate of Return (IRR). This is the discount rate at which the sum of all future cash flows discounted back to the same time period we paid our initial premium (time period 0) is exactly equal to that initial outflow. It’s an elegant piece of mathematics that Excel simplifies with its aptly named IRR formula. The brackets mean it’s an optional parameter but guessing can speed up the calculations. I guessed 5%.

=IRR(value,[guess])

The actual answer is 4.8%. Is that higher or lower than you expected? I was satisfied with my guess! The more important question: is that a good rate of return? Unfortunately, my answer is an unsatisfying “it depends”. I don’t think it’s very good for me, but my discount rate is 9.5%. Since the stock market averages 8% per annum, I knew the guaranteed return would be less to account for the insurance company’s operating costs and profits. To determine whether it’s good or bad, you have to decide if giving up an additional 3.2% average each year is worth the benefit of moving to a guaranteed fixed-income stream versus a variable one. I would tend to argue it’s usually not worth that hit in returns, but I’m sure there are some edge cases where it would make sense.

Additionally, what happens if I get hit by a bus tomorrow? The insurance company celebrates its payday, and my estate is $100k lighter than it would have been if I had kept my money in the stock market myself. On the flip side, if I live to be 100, the insurance company will be on the hook for continuing payments. You can model this by extending the columns and changing the IRR formula to include those additional values; living to 100 means my IRR increases from 4.8% to 5.3%. So the insurance company wins on some bets and loses on others. But even when they “lose” the percent that they’re paying out is still significantly under what the average stock market return is. My recommendation would be to put your entire holdings in either the Vanguard 500 Index Fund or the Target Retirement Fund closest to the date you want to retire and call it a day.

If that leaves you unsatisfied or with more questions than answers, then I have a 100% biased plug for my brother Heath Biller with Fiduciary Financial Advisors. He’s a fee-only financial advisor which means he earns no commissions and can give you specific advice for what’s best in your situation. Even if he wasn’t my brother, I’d still recommend him to anyone who wants help getting a handle on their finances. We share many of the same values and have overlapping thoughts on finances. Tell him I sent you, and maybe he’ll buy me a steak at Ruth’s Chris if you have a large portfolio.

He did review this blog and recommended I discuss inflation. While inflation affects both fixed-income accounts as well as variable-income accounts like stock portfolios, it hits the former disproportionately harder. If you earn nominal (before inflation) returns of 8% in the stock market, and inflation is 2%, your real return (i.e. your return after accounting for inflation) is 6%. That’s a 25% drop. If you earn a nominal return of 4.8% from an annuity with 2% inflation, your real return is 2.8% which is a 41.7% reduction! Ouch. 🤕😣

Once you retire or as you’re approaching retirement, it may make sense to convert some of your portfolio to fixed-income assets as your risk tolerance will likely be lower, but make that decision with your eyes wide open. You’re not avoiding commissions, sacrificing your upside, and exposing yourself to greatly increased inflation risk. You do get a guaranteed return, and there is some value in that. But I don’t think it’s worth what you’re giving up, and I don’t plan on buying annuities for myself anytime soon.

Here’s my cash flow calculations: