New Here? Get the Free Newsletter

Oblivious Investor offers a free newsletter providing tips on low-maintenance investing, tax planning, and retirement planning. Join over 11,000 email subscribers:

Articles are published Monday and Friday. You can unsubscribe at any time.

Annuity Payouts: Why Are They Higher than Bond Rates?

I often write about the usefulness of lifetime annuities — especially fixed, immediate, inflation-adjusted annuities — in retirement planning. (I find them helpful because they provide a relatively-high, predictable level of income.)

On occasion, people will tell me that they don’t want to buy a lifetime annuity. Instead, they plan to “build their own annuity” using bonds and other fixed-income investments.

Not annuitizing is perfectly fine. If you have enough savings to get by with a typical stock/bond portfolio, more power to you. But “building your own annuity” is not possible.

Sources of an Annuity’s Payout

The payout from a lifetime annuity comes from three sources:

  1. Your principal being paid back to you over time,
  2. The return on the investments that the insurance company buys with your principal, and
  3. Mortality credits.

The first two are not unique — you can get them just as well from bonds or bond funds. The third income source, however, is only provided by an annuity.

What’s a Mortality Credit?

Imagine that 1,000 65-year-old male investors each decide to purchase a lifetime annuity on the same date. The insurance company knows that it has to plan to make payments for, on average, 21 years for each annuitant. (Because a 65-year-old male has a life expectancy of 21 years.)

Of course, what really happens is this:

  • Some annuitants will live beyond their life expectancy, and the insurance company will have to make payments for more than 21 years.
  • Some of the annuitants will die before their life expectancy, thereby allowing the insurance company to use those annuitants’ money to fund the payments for still-living annuitants.

In other words: If you live beyond your life expectancy, annuities let you spend dead people’s money. (The portion of the annuity’s payout that’s composed of funds from deceased annuitants is known as the “mortality credit.”)

In turn, if you end up dying before your life expectancy, it will be your money that funds the payout for the annuities of still-living annuitants. That is, other annuity-owners will get your money rather than your heirs.

But that’s what makes the whole gig work. That’s precisely the reason that annuities provide for a significantly higher safe withdrawal rate than you can get from other fixed-income investments.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Comments

  1. Annuities are not a bad thing, but as you know folks really need to shop around. Expenses and payouts vary widely among annuity providers. Its always good to be a skeptical consumer, but especially here.

  2. Also never forget the company risk. I see to many people with their life savings wrapped up in an annuity with one company.

  3. @DIY Investor I totally agree, your comment is right on the mark.

Disclaimer: By using this site, you explicitly agree to its Terms of Use and agree not to hold Simple Subjects, LLC or any of its members liable in any way for damages arising from decisions you make based on the information made available on this site. I am not a financial or investment advisor, and the information on this site is for informational and entertainment purposes only and does not constitute financial advice.

Copyright 2014 Simple Subjects, LLC - All rights reserved. To be clear: This means that, aside from small quotations, the material on this site may not be republished elsewhere without my express permission. Terms of Use and Privacy Policy