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					    Why We Should Love
     (some) Annuities


       Houston Investors’ Association / Getting Started SIG / 8 Mar 2008



Leigh Anderson <hia@tayara.com>
Presentation at www.tayara.com/hia
             What is an annuity?
   A Contract
     • in return for a lump sum up front, it pays a
       guaranteed stream of income as long as you
       live
   Sort of like life insurance in reverse
     • Life insurance: bet you will die soon, transfer
       the financial risk of premature death
     • Annuity: bet you will live forever, transfer the
       financial risk of living too long (and going
       broke)

8 Mar 2008    Houston Investors Association / Getting Started SIG / Leigh Anderson   2
        Why might we need annuity in
               retirement?
   Investment return is uncertain: can
    be bad for years
   Lifetime uncertain: we may live
    much longer than expected
   “Safe” withdrawal rate from
    portfolios is about 4%/yr or less
     • may not be enough to live on
   An annuity gives more income,
    guaranteed for as long as we live
8 Mar 2008   Houston Investors Association / Getting Started SIG / Leigh Anderson   3
               Types of annuities
   Income Annuity (= Immediate Annuity)
     • Buy with lump sum up front; pays steady income
       continuously until death
   Deferred Annuity
     • Accumulates value (on tax-deferred basis) over time
       then converts to Income Annuity at retirement.
   Payment options
     • Fixed Annuities pay constant amount per month
       (optionally with inflation adjustment)
     • Variable Annuities pay varying amount based on
       investment returns
     • Equity index Annuities (EIA) promise partial upside of
       equity returns with guarantee of no losses

8 Mar 2008     Houston Investors Association / Getting Started SIG / Leigh Anderson   4
             Cave Canem
   Just as all dogs are not the same,
    neither are annuities
   “If it has to be sold, it’s probably not
    worth buying”
   Good (you have to seek them)
     • Low expense Income Annuities, either
       fixed or variable payments
     • Vanguard, TIAA-CREF
   Bad (pushed by high-commissioned
    brokers)
     • Deferred Annuities
     • Equity Index Annuities




8 Mar 2008      Houston Investors Association / Getting Started SIG / Leigh Anderson   5
    Income (or Immediate) Annuities
   Exchange lump sum of money for a guaranteed income
   Usually for life of investor (and possibly spouse)
   Less healthy annuitants receive age “rate-up”
     • increase income because of a shorter life expectancy
   Taxes
     • If funded from IRA, all income is taxable
     • If from after-tax funds, portion (about 60%) is “return of
       principal” and not taxed

   Income annuities improve standard of living
     • Higher income and lower risk than bond portfolio.
   Yet few people purchase income annuities.
     • Most accept SS and DB (if any) and invest the rest.
     • Many take lump sum option at retirement.


8 Mar 2008      Houston Investors Association / Getting Started SIG / Leigh Anderson   6
    Simplifying assumptions for examples

   Single male, retires at 65, with
    $100,000 lump sum in cash
   Life expectancy
     • 50% chance reaching 82.5 (17.5 years)
     • 10% chance reaching 94 (29 years)
   Interest rates (T-Bonds) 4.3%
   Will compare
     • Spending down a bond portfolio
     • Vanguard fixed payment annuity
8 Mar 2008   Houston Investors Association / Getting Started SIG / Leigh Anderson   7
        Example (ignoring inflation)
   Invest $100K in bond portfolio, spend
    down to $0 by age:
     • 82.5: $678/month income
                8.1%/yr withdrawal rate; 50% chance outliving
     • 94: $503/month income
                6.0%/yr withdrawal rate; 10% chance of outliving
   Use $100K to purchase Income Annuity
     • $725/month income
                8.7%/yr initial withdrawal rate; 0% outliving
     • Equivalent to 7.8% investment yield to age 94

8 Mar 2008            Houston Investors Association / Getting Started SIG / Leigh Anderson   8
    Example (payments adjusted for inflation)
     Increase income payments by 3%/year for
       inflation
   Invest $100K in Bond portfolio, spend
    down to $0
     • 82.5: $532/month inflation-adjusted income
                6.4%/yr withdrawal rate
     • 94: $345/month inflation-adjusted income
                4.0%/yr withdrawal rate
   Use $100K to purchase Income Annuity
    with inflation adjustment
     • $542/month inflation-adjusted income
                no risk of outliving; 6.5%/yr initial withdrawal rate
     • Equivalent to 8.0% investment yield

8 Mar 2008            Houston Investors Association / Getting Started SIG / Leigh Anderson   9
    Example (payments based on portfolio returns)

   Variable payments depending on performance of
    investments (stock, bonds, REITs, etc)
   “Assumed Investment Return” (AIR) of 3.5% or
    5% (your choice)
   Payments adjusted annually depending on
    excess/shortfall of performance
   Not adjusted for inflation, but stocks (in the long
    run) keep pace
   AIR 5%: $683/mo (8.2% initial withdrawal rate)
   AIR 3.5%: $592/mo (7.1% initial withdrawal
    rate)
   Income stream is variable
8 Mar 2008   Houston Investors Association / Getting Started SIG / Leigh Anderson   10
    Why is Vanguard So Generous?

   Because you might                                      die.
   When you manage your own portfolio,
    you assume longevity risk
     • Just like self-insuring your house
   When Vanguard insures you, you are
    pooled with everybody else
     • Some winners live to 99
     • Some losers check out early
     • It all evens out and the average age of 82.5
       determines payout rate

8 Mar 2008    Houston Investors Association / Getting Started SIG / Leigh Anderson   11
    Bad reasons why we don’t love annuities

   I want to leave something to the kids
     • OK, split your portfolio and annuitize half of it
   I might die too soon
     • Joint annuity provides for spouse
     • Period certain gives as much protection as you wish (at a cost)
   I’m worried about inflation
     • Buy an annuity with an inflation escalator
   The insurance company might go broke
     • Choose variable payments based on your portfolio balance
     • Buy two or more annuities from different providers
     • Avoid surrender fees that lock you in
   My employer offers a lousy pension (or might go broke); I
    took the lump sum
     • Use your lump sum to buy an annuity from Vanguard



8 Mar 2008       Houston Investors Association / Getting Started SIG / Leigh Anderson   12
The mental barriers
   Mental accounting: viewing risky decisions in isolation
     • “will I live long enough to get my principal back?”
     • But in retirement the financial risk is living too long, not dying
       too soon; an annuity reduces risk
   Loss aversion
     • Overestimate small probability of large loss from early death
     • Possible loss is more painful than equally likely gain of living
       past predicted age
   Regret avoidance
     • Annuities are illiquid. What if you change your mind?
     • Loss of control
   Overconfidence
     • I can beat the market
     • No Black Swans for me, thank you (I know the unknowable
       unknown)


8 Mar 2008       Houston Investors Association / Getting Started SIG / Leigh Anderson   13
Should you annuitize?
   Who shouldn’t
     • Income from portfolio meets your living requirements
       (with margin of safety for poor investment performance)
     • Health issues eliminate longevity “risk”
     • Strong need to maintain liquidity
     • Already have ample annuity-like income stream
   Who should
     • Investment income does not meet living requirements
     • Average or better health
     • Can commit to long-term strategy (low liquidity)




8 Mar 2008     Houston Investors Association / Getting Started SIG / Leigh Anderson   14
Leigh Anderson <hia@tayara.com>

                                         Book Shelf
   This presentation http://tayara.com/hia
   Vanguard website
    Overview
    http://www.aigretirementgold.com/vlip/VLIPController?page=Overview
    Calculator
    http://www.aigretirementgold.com/vlip/VLIPController?page=SubmitQuote
   United States Life Tables, 2003, CDC,
    http://www.cdc.gov/nchs/data/nvsr/nvsr54/nvsr54_14.pdf
   Behavioral obstacles in the annuity market, Financial
    Analysts Journal Dec. 2007
   American Association of Independent Investors
     •   Investment Products: If It Has to Be Sold, Don’t Buy It!
         http://www.aaii.com/includes/DisplayArticle.cfm?Article_Id=3275
     •   Annuities: The Good, the Bad and the Ugly
         http://www.aaii.com/includes/DisplayArticle.cfm?Article_Id=2901
     •   What You Need to Know About Immediate Annuities
         http://www.aaii.com/includes/DisplayArticle.cfm?Article_Id=3135

   What I did on my vacation www.tayara.com/travels



8 Mar 2008                Houston Investors Association / Getting Started SIG / Leigh Anderson   15
             Deferred Variable Annuity
   Advantages
     • Tax-deferred growth,
     • A death benefit,
     • The ability to convert the annuity into a lifetime income at a later date,
       and
     • Creditor protection
     • The tax-deferred growth feature is typically the sales pitch.
   Disadvantages
     • High costs,
     • All deferred returns are eventually taxed as ordinary income,
     • Loss of potential to avoid taxes on capital gains by awaiting a step-up
       in basis at death or donating appreciated shares to charity,
     • Inability to harvest losses to reduce taxes and loss of foreign tax
       credit,
     • Early surrender fees,
     • 10% penalty tax on withdrawals before age 59½, and
     • Investors must bear the credit risk of the insurance firms.



8 Mar 2008        Houston Investors Association / Getting Started SIG / Leigh Anderson   16