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Now you see it! Now you don’t! The Illusion of Immediate Annuities

By: Jason Whitby

By: Jason Whitby, MBA, CFA, CFP, AIFA

A recent study suggests that by adding an immediate annuity to a blend of stocks and bonds, you can increase the chance of “making your money last” from 77% to 100%! This study concludes that by placing half of your million dollar nest egg in the annuity, you can be absolutely guaranteed of having $40,000 a year adjusted for inflation for 30 years. But, there IS a hook; the average inflation rate over the next thirty years MUST be 2.5% or less!

The study successfully demonstrates the relationship between market risk and longevity risk. Unfortunately, the study barely mentions how market risk and longevity risk need to be further balanced against inflation risk, or more specifically, that your retirement portfolio should be designed to withstand shocks from the market and from inflation. As recently demonstrated, the market doesn’t produce average returns; it produces a wide range of returns that gives you an average. The same is true for inflation. Additionally, inflation has a universal impact on all of us while we have no control over it.

In order to demonstrate the impact of inflation, we re-ran the study to validate our model and then test the model for durability against a higher inflation rate. We used the return data from the study and replicated their 50%Stock/50%Bond portfolio withdrawing 4% annually and adjusting for inflation at 2.5% producing a 77% success rate, just as the study did. Next, we changed the mix to 25%Stock/25%Bond/50% immediate annuity, again replicating the study, and arriving at 100% success, just as the study did. But watch what happens when we change the average inflation rate over the next 30 years to 3%, 4%, or even 5%! Here are the results holding all else constant and only varying the inflation rate.

Table 1

25%Stock25%Bond 50%ImmediateAnnuity %Success
Inflation 2.5% 100%
Inflation 3.0% 96%
Inflation 4.0% 56%
Inflation 5.0% 11%

Table 1 illustrates that the fixed payout from the immediate annuity might help fight longevity risk but provides little ability to absorb inflation risk. At an average inflation rate of 4%, you only have a 56% chance of having your money last 30 years. And at a 5% inflation rate, your success rate drops to a frightening 11%! This is particularly relevant when you consider that the average 30-year inflation rate from 1973 to 2003 was 4.9% and 4.0% from 1978 to 2008. This 11% chance of success is a far cry from a guaranteed success and shows that the confidence some place in immediate annuities could turn out to be just an illusion.

I’m sure proponents of immediate annuities will say you can offset the inflation risk by adding an inflation adjustment to the immediate annuity. However, adding this feature drastically decreases the annuity payout well below the $40,000 a year target. Another suggestion is to spread your annuity purchase over a number of years. While this might help, it certainly isn’t practical and by no means guarantees success. Inflation can stay relatively flat for years and then jump up or down dramatically. There is a real possibility that you could stage your purchases over the next couple of years at relatively low levels only to see rates increase dramatically over a short period of time once you have committed all of your retirement money.

The data clearly shows that immediate annuities do not guarantee success in retirement even with reasonable inflation increases. Don’t believe anyone who tries to convince you that now is the time for immediate annuities, the data suggests otherwise.