insurance Archives - Page 3 of 3

July 10, 2014July 10, 2014

On Longevity Insurance – Do You Feel Lucky?

For starters, I hate most insurance products that purport to replace investment products. But I had not heard of longevity insurance until this week, so I decided to check it out.

Here’s the concept: Pay a big lump sum to an insurance company now (before retirement), in order to draw on a hefty fixed income many years in the future – but starting past the age you might not live to see.

The idea – known as longevity insurance or a deferred annuity – is meant to fit a certain type of person concerned with running out of money in the mixed-blessing event that he or she lives long enough to outlive most of his or her savings. By deferring the income for many years, a lump sum can create a significant income-for-life in later years, alleviating the risk that retirement money completely runs out.

This recent Bloomberg article offers the example of a 60 year old man who pays $125,000 to New York Life today in order to draw nearly $45,000 a year, starting at age 80 – twenty years from now. This article says New York Life offers $17,614 guaranteed annual income after age 80 for a $50,000 premium.[1]

The article claims a retiree’s account must grow by an unlikely 11% to match the income available from this type of deferred annuity, without specifying exactly how that percentage was calculated.

You think this is the equivalent of 11% return?

11% return?

“Go ahead. Make my day.”

https://www.youtube.com/watch?v=cg-NNSEPClQ

I’ll use the latter Bloomberg article’s precise numbers later in this post to calculate what I think about all this, from a financial perspective.

To think about the numbers and the math behind longevity insurance, it’s helpful – regrettably – to think about the probabilities of death.

Stats about death probabilities

We know from Social Security’s actuarial tables that the risk of death between 60 and 80 – meaning in this case the risk of paying over a big lump sum and getting exactly nothing back – is significant.

The probability of death at any age each year rises, for a man[2], from about 1.1% for 60 year olds, to about 6% for 80 year olds. Combine the annual risk of death for every year between 60 and 80, and we can see – actually we know this instinctively, but still we can see – that this deferred annuity could end up worth zero.

The sum of all the one-year probabilities of death, for a man, between age 60 through age 79 is 54%, meaning that there’s a greater than 50% chance that the annuity income is never collected.

This all may seem morbid to talk about, but as my friend Clint says in The Unforgiven, “We all have it coming, kid.”

https://www.youtube.com/watch?v=XoAPKt7kbD0

Here are some other interesting and relevant, stats from the SS actuarial tables:

A 60 year old man has an expected life of 21.27 more years. This means the average man has just 1.27 years past age 80, on average, to receive guaranteed income from the longevity insurance annuity. Taken at face value, that seems like very few years, on average, to received guaranteed income after age 80.

Next, should that man make it to age 80, the expected life from that point onward is 8.1 years. That seems more palatable from a financial perspective, and instinctively the guaranteed income for 8 years sounds more reasonable. Below I will do some math, however, to move from ‘instinct’ to ‘calculation.’

Insurance for high-probability events

Now, the low probability of receiving ‘fair value’ for this annuity premium is not – in itself – a reason to avoid longevity insurance. Insurance, after all, can make sense even for low probability events.

I pay for home insurance against complete outlier events like devastating fires or meteor crashes, even though, chances are, these won’t happen in my lifetime. (quickly knocking wood).

But since living and dying are not outlier events, but rather guaranteed events with an uncertain time schedule, I have to consider only a part as insurance against the unknown and part as a straight-up financial investment around a known event, with adjustments for the probabilities of living a certain amount of time, within a limited range – e.g. greater than zero, and something less than 45, for a 60 year old man.

Calculating the returns of longevity insurance

So what does the financial return of longevity insurance look like?

We can use a combination of discounted cash flow and compound interest calculations to answer this question.

In the New York Life quote in the Bloomberg article cited above, a 60 year old man can pay $50,000 and receive an annual income of $17,614, guaranteed for life, starting at age 80.

I’ll cover 4 scenarios for this type of longevity insurance, plus 1 alternate scenario of not buying the insurance.

Clint says it best in A Fistful of Dollars: “Get 3 coffins ready. My mistake, four coffins.”

https://www.youtube.com/watch?v=KZ_7br_3y54

Scenario #1 – The 60 year old dies before age 80, receives no income

In this sad case, the insurance company pockets the $50,000 premium and pays out nothing in guaranteed income. Obviously, from a pure financial standpoint, this is a losing trade. Also, this will happen 54% of the time, for the average 60 year old considering this purchase.

The Outlaw Josey Wales says it best: “Dyin’ aint much of a living, boy. You know this isn’t necessary. You can just ride on.”

https://www.youtube.com/watch?v=Bigc7GXHU50

Scenario #2 – The average 60 year old man

Let’s say the man lives to the 60 year old’s average of 21.27 additional years, or 1.27 years past age 80.

That 60 year old man today can expect to collect $22,369.78 total in annuity income (that’s 1.27 * $17,614).

But that average future income is quoted in future dollars, so we need to know the present value of those dollars, discounted to the present day.

We use the discounted cash flow formula PV = FV / (1+Y)^N in which

PV = Present Value – That’s what we want to figure out.

FV = Future Value – That’s $22,369.78 in this example.

Y = Some assumed interest rate. Let’s say 5% because that’s close to where NY Life discounts retirement benefits for its employees, according to their 2013 financial statement.

N = Number of years. That’s 20 years in this example.

So plugging those number into the PV = FV/ (1+Y)^N formula, our present value tell us that the future income is worth $8,430.93

Since I’m paying $50,000 today to receive the equivalent value in today’s dollars of $8,430.93, I’m not particularly excited about the value of this product for the average 60 year old man in scenario #2.

The High Plains Drifter is keeping up with this math, so I hope you are.

“How ‘bout it stranger? Think you’re fast enough to keep up with us?”

“A lot faster than you’ll ever live to be.”

https://www.youtube.com/watch?v=vL2la06bUns

Scenario #3 – Today’s 60 year-old man lives to age 85.

Again, we will apply the discounted cash flow formula, but now we have 5 years’ worth of receiving a guaranteed annual income of $17,614. More palatable, I think. But let me see what the numbers say.[3]

To figure out the total value of this income – to a hypothetical 60 year-old man living to age 85 – we’ll need to add up the individual values of the annual incomes for each of the years. So, the sum of 5 PVs, using the same PV = FV / (1+Y)^N, just calculated 5 times.

Income Year #1 (through age 81):

FV = $17,614, Y = 5%, N = 20

So, PV = $6,638.53

Income Year #2 (through Age 82):

FV = $17,614, Y = 5%, N = 21

So, PV = $6,322.41

Income Year #3 (through age 83):

FV = $17,614, Y = 5%, N = 22

So, PV = $6,021.34

Income Year #4, (through age 84):

FV = $17,614, Y = 5%, N = 23

So, PV = $5,734.61

Income Year #5, (through age 85):

FV = $17,614, Y = 5%, N = 24

And so, PV = $5,461.54

At the end of all this – admittedly much easier to do and show in a spreadsheet – The total value in today’s dollars is $30,178.43, compared to the $50,000 premium required to receive this value.

Even living to age 85, I still much prefer the insurance company’s side of the deal rather than the hypothetical 60-year-old’s deal.

Scenario #4 – The 60 year-old man lives to age 90

I’m going to fast-forward on all the formula stuff, but in this case all that is required for your calculations is to discount the annual $17,614 by ten different discount rates. The total present value at the end of ten years of income is $53,824.03. This, finally, compares favorably to the $50,000 premium. So, from a purely financial standpoint, you start to get the positive side of the deal between years nine and ten after age 80. Enjoy!

Also, by then you’ll be this guy, gruffly shouting at his neighbors to “get off my lawn!”

https://www.youtube.com/watch?v=NelBNtNm8l0

This assumes, of course, that 5% is the right discount rate. In other words, can you achieve an after tax return of 5%, comparable to the discount rate? If you can achieve a better return in the market, then the breakeven is significantly longer than ten years. If you think you can achieve only a 2% return outside of this deferred annuity, then your breakeven point is between four and five years.

Alternate scenario

What about that “equivalent to 11% return” quoted in the Bloomberg article? First off, I have no idea how that’s possible, and the author of the article doesn’t say. My guess is that number came straight from New York Life, and the author made no attempt to reproduce those numbers. So, shame on him.

However, we can look at what happens if you invest the $50,000 in market securities at age 60 instead of purchasing a deferred annuity.

For that, we use the compound interest formula, which is just the inverse of the discounted cash flows formula: FV = PV * (1+Y)^N, where:

FV = Future Value – what we’re trying to calculate.

PV = Present Value – That’s $50,000 in our example.

Y = Some assumed interest rate. I’ll stick with 5% for consistency’s sake.

N = Number of years of compounding. N is 20 in our example, to get to age 80. And then we can look at larger Ns, for later years, as the invested amount continues to grow.

Our $50,000, invested in the market and returning a compounded 5% annual growth, becomes $132,665.

Which, if you might die before age 80, you’re significantly better off than if had you paid that $50,000 as a lump sum to New York Life at age 60.

Now, to take income from that $132,665 at age 80 you’ll need to decide at what rate to draw it.

If you decide to withdraw 10% of the total every year – and assuming an after-tax 5% return as well – then at the end of ten years you’ll still have $70,204 left. You’ll also draw a declining income between $13k and $7.5K. That income isn’t great, but you’ll actually have some wealth you can still call your own at age 90, which can be something useful.

If you decide instead to withdraw the fixed $17,614 per year – to match the annuity assumption – again we see that the break-even is between years nine and ten, with one significant difference: There’s money left over for heirs if you die at any time between age 80 and 90 when you invest it yourself, rather than convert it to an annuity. With an annuity, there’s no money left over, ever.

Insurance companies and financial journalists generally don’t want to talk about the poor returns of their investment products.

Which kind of puts me in the mindset of certain elderly gentleman in Detroit, “You ever notice how you come across somebody once in a while you shouldn’t have fucked with? That’s me.”

https://www.youtube.com/watch?v=ny6SJCNUzqY

In sum

I don’t know. Obviously I started out as an insurance-product skeptic, and this exercise did not convince me otherwise. From the math I’m looking at, the vast majority of people would do better by investing their own money for retirement rather than turning over lump sums to an insurance company to receive unlikely income of dubious, low value.

I’ve addressed the pure-finance angle, but some people want total certainty, and they crave a fixed income for life with no risk.

The rest of us, I think, should live with the gamble.

In the end, I must turn again to Dirty Harry to summarize.

Knowing the break-even point is between nine and ten years of guaranteed income for your life past age 80 in the example quoted by New York Life, you have a clear calculation to make.

Now, I know what you’re thinking.

“Will I live 10 more years past 80, or only nine?”

To tell you the truth, in all this excitement, I’ve forgotten myself.

So you have to ask this yourself question:

Do I feel lucky?

Huh punk? Do you?

Please also see related posts on:

Calculating Discounted Cash Flows

Insurance I – Risk Transfer Only

Insurance II – The Good, The Optional, and The Bad

Insurance III – Life Insurance As An Investment

Ask an Ex-Banker – Should I buy an Annuity?

Compound Interest – The Most Powerful Force in the Universe

[1] The article also mentions a few technical details. The US Treasury has recently made longevity insurance more viable by allowing up to either 25% or a maximum of $125,000 in retirement accounts to invest in deferred annuities like this. Longevity insurance makes up less than 1% of the market right now for insurance, but may grow as insurance marketing kicks in, and the US Treasury rule which began in January 2014 ‘normalizes’ the product.

[2] I’m going to just use the calculations for a man, because it makes it easier for me and the Bloomberg article did not give a price quote for longevity insurance for a woman. We can assume, however, that the income payout will be somewhat lower for a woman, because women live longer on average and the insurance companies will adjust their income payouts accordingly.

[3] I’m going to belabor this point by showing all of the discounted cash-flow math, because the highest wish of my life is that Bankers Anonymous readers will follow along with spreadsheets to see how useful discounting cash-flows can be to understanding finance. So – humor me?

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June 28, 2014June 28, 2014

Guest Post: Don’t Buy Too Much Insurance!

Editor’s Note: Lars Kroijer, semi-regular contributor here and author of Investing Demystified, offers one of the two most important principles of Insurance: Namely, don’t buy too much of it. In this post he uses the simple example of auto insurance – which because of state laws in the US we must buy – to argue that less insurance is generally better. Even though we cannot avoid auto insurance altogether, we can apply this same principal to other types of insurance. Take it away, Lars…

In very rough terms the world of insurance is divided into life and non-life insurance. Non-life insurance is for things like your car, house, travel, company, and other non-life things. We all know how it works. You pay $500 to insure your car against a number of things, including for example theft. Let’s say it is a $10,000 value car. In simple terms, the probability of making a claim against the full value of the car in any one year has to be 5%. Without necessarily doing it in those terms, most buyers of insurance probably consider that about right and therefore worth it.

The reason I would not prefer to buy the $500 insurance on my $10,000 car – other than the insurance that is required by law – has to do with my knowledge of the insurance company’s combined ratio. The combined ratio is the sum of the claims and expense ratio. The claims ratio is exactly that – what the company pays out in claims to people whose cars were stolen or damaged. And the expense ratio is all the other costs of the insurance company; marketing, administration, overhead, etc. Insurance companies can have combined ratios over 100%; if claims don’t come due for a while the insurers earn an interest on the premiums they collected until the claim falls due. But since car insurance is typically a one year policy the combined ratio for this policy should be below 100%, in order for the insurance policy to be profitable for the insurance company.

For car insurance the risks are somewhat predictable and the insurance company are likely to have a good idea of the number of claims and expenses they will face (insurers can reinsure risks they don’t wish to hold fully themselves). Using very rough numbers the insurance company might have a combined ratio of 95% for these policies made up of a 70% claims ratio and 25% expense ratio (my friends in insurance will bemoan this simplification). So essentially if you are an average risk customer, for every time you pay $100 in premium on your car insurance you get $70 back in claims and it costs $25 for the insurance company to make it all happen, and they take a $5 profit. Put in other words, you are paying $30 for the peace of mind of having the insurance.

When I describe it this way, I am simplifying the amounts and the process. You obviously don’t get $70 back. Most of the time you get nothing back as you didn’t make a claim on the insurance company, and then when misfortune strikes you get your $10,000 back; on average you get $70 back.

So the reason I don’t buy extra insurance above what’s required by law is that I don’t want to pay the 30% in cases where I can afford the loss (25% expenses plus 5% profit to the insurance company). Obviously it would really stink to have my car stolen or damaged to the tune of the full $10,000, but I see this as a risk I can afford to bear and don’t need to pay to protect against. Importantly I don’t think that I save the full $500 in annual car insurance. I think that I save the 30% difference between what I paid and the average claims. In my view the insurance company knows as much about my risk as buyer of insurance as I do, and if they set the average pay-out for me at 70% of a $500 policy then that is probably about right. So using this case of car insurance to extrapolate how I think about insurance in general, on average over all the insurance policies I don’t buy I would expect to have a loss of $350 (70% of $500) on my car in any one year, and have saved $150 by not buying insurance (30% of $500).

Not buying insurance against things we can afford to replace or have happen does not mean that those things don’t happen. It just means that instead of having the small bleed of constantly paying small premiums for lots of small things we will once in a while be paying out larger replacements amounts for things we did not insure against. Personally I also think the whole hassle of keeping track of insurance policies is a pain I would rather avoid and I also seem to constantly hear stories about insurance companies that either fought claims or made claiming on a policy a huge headache.

Without being scientific about it including all insurance forms that I don’t buy (including life insurance) I think I save about $500 per year in expense ratio and insurance company profit. Assuming that I took this money every year for the next 30 years and invested it in the broader equity markets and was able to return 5% on that money, my savings from not buying insurance over the period would amount to around $35,000 in present money. This is money I have, instead of it being in the insurance company’s pockets in 30 years. Importantly this saving does not assume that I do not have accidents or have my car stolen. In fact it assumes that I am at risk of those things exactly with the same probability that the insurance companies assume.

Investment advice typically has an “always seek expert advice” or “don’t try this at home” disclaimer, but here it really applies. You should not save on insurance premium payments in instances where you can’t afford the loss; and everyone is different in terms of what they can afford to lose. Most people could not afford to lose their house in a fire so they should insure against this possibility (you probably couldn’t get a mortgage if you didn’t). Most people in countries without national health services couldn’t afford bad health reverses and should get health insurance. Many can’t afford to have bad things happen to their car or their homes broken in to, so they should insure against that.

Try to save your money from all these nice folks

But, importantly, most people can afford to lose their mobile phone, having to cancel a flight or vacation, or an increase in the price of their electricity bill, and they should not insure against those things. And even if there are things you need to buy insurance for you should always get a high deductible which in turn will lower the cost of the insurance policy. Over time having no insurance or a high deductible when you do will save you quite a bit of money, and that should make you sleep better at night.

Similarly there are many instances where life insurance makes sense. As with the case of annuities many life products have an investment component to them, but obviously also a life component. If you are in a situation where your death or disability will cause unbearable financial stress on your descendants then the premium you pay on these policies make sense. As with the example of car insurance, you should do so when you or your descendants can’t afford the loss. Whether they can or not is obviously a highly individual thing, but bear in mind that as with all insurance products there is a tangible financial cost to the intangible peace of mind many people cherish in insurance. Make sure it is worth it.

Please see related posts:

Insurance Part I – Risk Transfer Only

Insurance Part II – The Good, The Optional, The Bad

Insurance Part III – Life Insurance Calculations

Book Review: Investing Demystified by Lars Kroijer

Audio Interview with Lars Kroijer, Part I – Global Diversification

Audio Interview with Lars Kroijer, Part II – On Having an Edge in Investing

Guest Post by Lars Kroijer: You don’t have an investing edge

Also, see book review about an author obsessed with auto insurance, in My Vast Fortune by Andrew Tobias

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May 7, 2013May 8, 2013

On Insurance, Part II – The Good, The Optional, & The Bad

Please see my previous post, on Insurance as Risk Transfer Only

Good uses of insurance

Car insurance – mandatory and necessary, appropriately transfers risk of sudden damage to car or bodily health away from you to a company that can spread that risk around.
Homeowners and renters insurance – similarly transfers risk of catastrophic damage to real and personal property to a company with enough capital to accept diversified risk. The wealthier you are when you buy the insurance, the larger the deductible you can and should afford.
Health insurance – transfers the risk of high or catastrophic health-care costs and is absolutely necessary to well-being and wealth.

Optional uses of insurance

If you find yourself the primary or sole caregiver of minor children, and you have limited savings, the next 2 types of risk transfer are mandatory. Otherwise they’re optional.

Disability Insurance – Transfer the risk of a loss of earnings and earnings potential. You need to buy enough insurance that you could feed, clothe and house yourself and your dependents. With no dependents, you have much less need for this type of insurance.
Life Insurance – Remember: This is not a good way to invest. This is only a good way to provide for minor children or a non-working spouse should you die. Because I urge life insurance as a risk transfer only, and not as an investment, I lean toward term life insurance for the duration of your children’s minority years. Once they’re 18, or 22 if college bound, they can fend for themselves. Term life insurance increases the likelihood that you will calculate only the amount of insurance you need to transfer risk and not get caught up in the sales pitch that life insurance is a good investment. Remember, it’s not.

Bad uses of Insurance

6. Warranties – I’m indifferent to car warranties, as I don’t know enough about them. But electronics warranties are a complete waste of your money. It’s extra insurance you do not need, on an ‘asset’ which depreciates in value faster than you can count backwards from 100. The warranty company depends on you neglecting to exchange your electronic device, because in 2 years there’s something better out there anyway. As I wrote earlier, warranties are the ultimate “neglect-based” business, along with life insurance policies.

7. Car Rental Insurance – Chances are you’re already double-covered by your own automobile insurance, as well as insurance from your credit card.

Have you noticed the rental agencies really like to push three difference types of insurance on you? Unless you’ve got a very special situation, you don’t need that stuff.

“Can I at least put you down for bumper to bumper coverage?” Stop. Bugging. Me.

6. Variable Annuity – Monstrosity. The chimera that neither breathes fire nor flies straight. High cost, low return, illiquid. Perfect!

Here’s a quick quiz:

Question: Why does the Wall Street Journal always carry headlines such as: “Are variable annuities a good idea or just too costly?” instead of more honest headlines like “Are you a moron who likes to be separated from your money? Try variable annuities!”? [1]

Answer: An awful lot of insurance company advertisers vie for eyeballs right next to that variable annuity article.

Please see related posts Insurance, Part I – Risk Transfer Only

and

Insurance Part III – Calculations of Life Insurance as an investment

[1] The authors of these variable annuity articles seemingly know they’re terrible, but they also seem to know who pays the bills. I feel badly for them, writing the articles must be torture. Here’s a few recent samples from the Wall Street Journal this Spring: “Cheaper Annuities With Benefits,” “New Annuity Guarantees Raise Questions,” and “They’re Changing Our Annuity!”

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August 24, 2012October 29, 2014

Ask an Ex-Banker: Annuities!

Q: I am thinking about buying an annuity. I want to generate dependable income, BUT, how do I make sense out of whether or not an annuity is a good investment in addition to providing a degree of comfort. The tradeoff seems a big gamble, i.e. how long I will live. –Captain Bill H., Friendship, Maine.

A: Apparently annuities are a growing segment of the retirement market, so Bill, your question is timely.

I thought it would be useful to explain how a banker thinks of an annuity. By “banker,” I also mean to explain how your insurance company thinks of the annuity they’re offering you.

From the banker’s – as well as insurance company’s – perspective, an annuity is a great deal, and it’s not a gamble. From your perspective, the story is more mixed.

HOW A BANKER OR INSURANCE COMPANY THINKS OF AN ANNUITY

First off, your insurance company – despite what your friendly insurance broker may tell you – does not offer you the annuity to “guaranty your financial health,” “generate dependable income,” “protect your loved-ones,” or to “make sure you have sufficient income in your retirement years.” The insurance company, instead, is an investor maximizing its profit. When considering an annuity, let’s always keep that in mind first.

Now, like all for-profit financial companies in the known solar system, your insurance company seeks to buy money cheaply and to sell money expensively. This falls under the well-known investment activity: “Buy low, sell high.”

I do not mean to be obtuse when I write “buy money cheaply,” since to the non-financial person “buying money” may begin to sound like Orwellian tautology, but bear with me for a moment. Financial people -including the people who employ your friendly insurance broker – definitely think of their business as buying cheap money and selling expensive money.

Now let’s briefly peek ahead at the Answer Key in the back of this blog: your annuity represents an opportunity to buy cheap money for the insurance company.

Ok, back to the main text of my answer.

All insurance companies need a massive pile of money to operate,[1] so they constantly evaluate the best ways of buying money. When acquiring money, insurance companies have a choice of where to get their money. I’ll run through the three main ways:

Sometimes insurance companies acquire equity capital through the sale of shares to private or public stock investors. In other words, the companies sell part of themselves to other owners, in exchange for money. All publically owned insurance companies have done this. Equity capital is typically considered extremely expensive money, so insurance companies do this only as a last resort.[2]
Often insurance companies acquire debtor capital money, otherwise known as borrowing, possibly from a bank but more commonly in the form of a bond from institutional investors. An investment grade insurance company[3] may be able to borrow $1 Billion for 10 years right now at, say, 4% in the bond market. This means the insurance company gets use of $1 Billion, it pays $40 million per year in interest for that privilege, and then it returns the $1 Billion in principal at the end of 10 years. Since rates are historically low right now, and the institutional bond market is extremely efficient at providing capital to insurance companies, this is a great way for insurance companies to acquire money on the cheap.
And finally, there’s rock-bottom cheap money: your annuity.[4] Given all the costs of acquiring you as a customer[5] and servicing your annuity for your life, plus the retail nature (ie. small size) of the money you’re providing to the insurance company, you would expect this money to be VERY cheap indeed, to make it all worthwhile for the insurance company. Again, remember, they don’t actually care about all the comforting things President Palmer talks about during the Allstate ads. To provide you, the customer, with an annuity, it’s got to be really cheap money. If it wasn’t super cheap, they would just borrow money from the bond markets.

How cheap is cheap? I just went on my own personal preferred insurance company/bank’s website[6] and applied for a $100,000 annuity. I’m 40 years old and applied for a lifetime monthly annuity, with a (fairly typical) 20 years of guaranteed payments.[7] In exchange for my upfront $100,000, the company offered $358.39/month for the rest of my life. The company guarantees that, even if I die suddenly, the first 20 years, or 240 monthly payments, will be paid to my heirs, for a guaranteed payment amount of $86,013.60.

Now, if you’ve been following closely up until now, you’ll already know that I set up my answer to Bill’s question as a less than ringing endorsement for annuities, but the actual quote allows us to see exactly how good or bad the annuity opportunity is in pure financial terms, for both the insurance company and the annuity buyer.[8]

The insurance company will never tell you the cost of borrowing money from their perspective, but I will share with you what their cost would be for my specific annuity.

If I live my expected[9] additional 37.8 years to the ripe old age of 77.8 then the insurance company’s cost of money is 2.79%.[10] Another way of thinking about the calculation is that I would earn 2.79% annually on my $100,000 for the next 38 years if I am lucky enough to live that long. If I’m unlucky, and live fewer years, then my insurance company effectively borrows money at substantially less than 2.79%, possibly below a 0% cost of funds. In that early death scenario, they get money that’s cheaper than free! Equivalently stated, the % return that I receive on my annuity could be negative if I die before my expected time.[11]

If, instead, I live as long as I expect to live, that is to say, until age 100,[12] then my return can be as high as 3.84%, and the insurance company’s cost of funds is equivalently 3.84%. Notice this is still below the 4% they can expect to pay to borrow money in the bond market, making an individual annuity worthwhile to them even if I far exceed my life expectancy.

Let’s take another example. Let’s say Bill, the original questioner above, is a 70 year old man, who can expect an additional 13.7 more years, according to the Social Security actuarial tables, living to the wise old age of 83.7. I applied online to my same insurance company as a 70-year-old man,[13] willing to take just 10 years of guaranteed payments (a reasonable scenario rather than the 20 years of guaranteed payments that a 40 year old might want.) For his $100,000 annuity premium, Bill could expect to receive $597.19/month for the rest of his life with 120 guaranteed payments.

What is the insurance company’s cost of funds in this case, and conversely, Bill’s expected return? If Bill lives to his expected life-span, he would receive a total of $98,536.35, or less than he paid upfront for the annuity, for a negative return on his money. In other words, under a reasonable baseline scenario, the insurance company acquires money at a negative rate of interest. That’s better than free! That’s awesome. If you’re a death-eating, snake-tattoo-on-your-arm annuity provider, of course.

Now, if Bill also lives, as I’m sure he expects to, until the ripe age of 100, he can expect a much improved 5.92% return on his investment, while the insurance company conversely incurs an expensive cost of borrowing from Bill, at 5.92%. However, the insurance company has wisely balanced the probability of free money under an ordinary scenario (Bill lives to his expected life span) versus the very remote probability of maxing out at 5.92%, if Bill hangs on to this mortal coil for a whole century.

Now, I have few rules in life, but one of them is that when you can acquire money somewhere between free and 5.9%, with the probabilities skewing much closer to free, well then you should acquire as much money that way as possible. And figure out what to do with it later. Like, for example, build massive skyscrapers with your money. In a related piece of news, has anyone else noticed that insurance company skyscrapers dominate most major US city skylines? Your death, plus your neglect, help make this happen. I’m just sayin’.

OTHER FACTORS BESIDES RETURN/COST OF FUNDS – SAUSAGE MAKING

In addition to the cost of money for an insurance company, it’s worth understanding another reason insurance companies seek to provide annuities. Most annuity providers are also life insurance companies. This makes sense in the same way that a sophisticated slaughterhouse might provide both premium sausage meat and processed hog food, as one customer’s premature death is balanced by, or better said, hedged by, another customer’s unfortunate longevity.

What do I mean by this? A life insurance policy allows the insurance company the opportunity to collect regular, moderate – typically monthly – premiums. For that opportunity, the insurance company has the obligation to pay out a substantial lump sum upon the death of the insured person. An annuity is the mirror image of a life policy. The insurance company has the opportunity to collect a substantial lump sum up front, and then takes on the responsibility, or liability, to pay out regular, moderate – typically monthly – premiums. When the life insured customer dies, the insurance company “loses.” When the annuity customer dies, the insurance company “wins.” When a company can offer both life insurance and annuities simultaneously, it creates an efficient kind of perpetual sausage-making machine in which money can be continually bought cheaply and sold expensively.

A rash of deaths causing a string of sudden life-insurance payouts can be compensated by a release of the obligation to pay ongoing annuity income to the newly dead. It all works out nicely. If you’re an insurance company.

SHOULD BILL GET AN ANNUITY?

Now that we know the range of investment returns we can expect on an annuity, does it make sense to purchase an annuity, Bill’s original question?

The answer to Bill’s original question is obviously more complex than can be understood in terms of cheap money and expensive money, even if that’s the primary lens of a banker or an insurance company.

The appropriateness of an annuity for any individual owes quite a bit to the individual’s appetite for risk. To return to geometry class, picture the XY axis where X shows an arrow of increasing risk and Y shows an arrow of increasing return. The annuity represents one of the lowest risk and return assets you can possibly acquire, pretty much right next to the 0,0 point on the graph, just above and to the right of straight cash.

If you don’t mind providing free money to insurance companies, and you quite like the idea of cash-like returns, then annuities could be just the thing for you. When you think of if that way, annuities are a perfectly reasonable cash substitute. Despite S&Ps recent warning, State and Federal regulators manage to make the insurance industry a safe place to park funds for life, as long as you understand a) that the return will be terrible and b) the insurance/annuity provider will never, ever, tell you the return you are getting. That information, if disclosed, would embarrass them. And it’s hard to build skyscrapers when you’re feeling embarrassed.

For more on annuities and using the mathematics of discounted cashflows to evaluate them, please see this post:

Discounted Cashflows – Using the math to evaluate an annuity.

[1] Like a bank, the main requirement for operating an insurance company is to have a pile of money. None of the other functions and requirements for operating an insurance company matter much if you don’t start with a pile or money and then maintain it at all times. Once that pile of money shrinks, it doesn’t matter how good you are at the rest of the things that go into being an insurance company, you’re out of business.

[2] Like for example how Credit-crunch-poster-child-insurance-company AIG sold $17.4 Billion worth of shares in 2012, because, well, how else are they going to get money? No one wanted to give them money anymore since they were a root cause and casualty of the 2008 Credit Crunch.

[3] I acknowledge “investment grade insurance company” is a bit of a redundancy in the US context, since non-investment grade insurance companies are generally not allowed to operate, but rather are put into a special receivership status by federal or state regulators, and their portfolios allowed to run off over time. Sometimes this takes decades. I have invested in annuities like this via my investment business, but I digress.

[4] It may not have been apparent to you as an annuity customer until now, but essentially you’re lending money, just like a bond, to the insurance company. Instead of a $1 Billion loan in the form of a bond, you might turn over $100,000 up front in the form of an annuity. But then – just like a bond – the insurance company has an obligation to provide regular payments back to you in exchange for use of your money. One great aspect of this loan-in-the-shape-of-an-annuity, is that the loan isn’t limited to, for example, 10 years, like a bond. In fact, the loan is forever. You see, the really cool thing about your loan/annuity, (from the insurance company’s perspective) is that they never have to pay you back the principal! You just die, and they keep the $100,000 of your money! Seriously, how great is that? The answer is: very great, as long as you’re an insurance company.

[5] Advertising, monthly statements, fund transfers, investment disclosures, customer service for your lifetime, plus all those drinks your insurance broker provided you at the Golf Club…none of this comes cheap people!

[6] I do all my banking and insurance with USAA because their customer service absolutely rocks. It’s leaps and bounds better than any other major customer service business I’ve ever dealt with. Regardless of their customer service awesomeness, I believe their annuity quote to be typical. Let this footnote serve as my unsolicited highest endorsement of USAA, although there’s no absolutely no tie between me or Bankers Anonymous and USAA. But I kind of wish there was. USAA, hit me up, I could be your President Palmer. Call me, maybe.

[7] Just to walk you thought the thought process if you’ve never applied for an annuity, its common to request an annuity quote for lifetime payments with some period of payments guaranteed to avoid the “I bought the annuity today for a big premium but got hit by a bus next month” problem that most annuity buyers would never be able to overcome. So, typically you buy lifetime payments and the annuity/insurance company agrees to pay your designated heirs at least some year’s worth of payments if you die suddenly. For a relatively young person a 20year guarantee is not atypical. A much older person might choose a shorter guaranteed payment period, like 5 or 10 years guaranteed.

[8] Incidentally, I’m 99% sure that insurance companies never provide a % return estimate for annuities of the type I’m providing in the main text paragraphs to follow. So the fact that I’m providing this clear-headed financial return analysis may be largely attributed to two factors: a). I’m your best friend, and b). Insurance Companies are not your friend.

[9] Have you ever wondered what your expected lifespan is, as well as your probability of death in any given year? The Social Security administration has the answers. Not only am I your best friend, but I can predict your date of death as well. Weird. It’s like I have special powers. Anyway, you’re welcome.

[10] How did I get this % interest rate? I’m kind of glad you asked. Join me a little way down the financial rabbit hole. I got there by applying a single Discount Rate to a formula for figuring out the present value of all the expected future cash-flows. What is a Discount Rate? That’s the single % rate I can apply to all the future cash-flows of an annuity which add up to $100,000 (my original annuity cost). The formula for each single cash flow is “Nth Annuity Payment” in the numerator divided by a denominator of (1+Discount Rate/12) raised to the power of the Nth payment. I know this makes absolutely no sense if you haven’t already worked with the formula before, but my wife made me put it in here. I’ll tell you what, how about some curious and astute reader sends me a note asking me to explain discounted cash flows and I’ll do a whole post about it sometime soon. Is that a deal? In the meantime, trust me that this is how every bank and insurance company evaluates the amount they’ll pay you for your annuity.

[11] If you have a paranoid frame of mind, you can see how the annuity provider begins to resemble a financial vulture, hoping for your premature demise so they can get free money. Does the flapping of their wings smell like death to you as well?

[12] In the year 2072, I’m comforted in my old age by my bedside Rihanna clone – scientifically engineered to remain 24 years old. I die quietly in my sleep on our hovercraft, while she lullabies “SOS” until a pass to the next world.

[13] Let’s just agree to call me Harrison, shall we?

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