3% annuity costs a little more than a CPI-U adjusted one

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peter_s
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3% annuity costs a little more than a CPI-U adjusted one

Post by peter_s »

While revisiting the idea of using annuities in our financial plans, I obtained the following quotes this evening for a $1000/month single life annuity from AIG through the Vanguard hosted Income Solutions site, for my wife, age 66:

1000/month fixed: 186,075 (6.4%)
1000/month, with 3% annual increase compounded per year: 258,796 (4.6%)
1000/month, CPI-U adjusted upward: 251,347 (4.8%)

Which one would you choose (if you were choosing)?
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alec
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Re: 3% annuity costs a little more than a CPI-U adjusted one

Post by alec »

If it were me, I'd chose the CPI-U adjusted one, but only after delaying social security as long as possible.

If I went with the 3% annual increase, and the CPI-U turned out to be 4-7% per year for a number of years, seems like my standard of living would be adversely affected.
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randomguy
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Re: 3% annuity costs a little more than a CPI-U adjusted one

Post by randomguy »

alec wrote:If it were me, I'd chose the CPI-U adjusted one, but only after delaying social security as long as possible.

If I went with the 3% annual increase, and the CPI-U turned out to be 4-7% per year for a number of years, seems like my standard of living would be adversely affected.
I would go for the fixed one and just buy 70k more of it (or invest it in tips or a longevity annuity). The 3% option really isn't worth it. It doesn't hedge against any of the risk (high inflation).

To some extent you can't just look at the annuity in isolation. You need to look into how it integrates with everything else you have and you needs.
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Re: 3% annuity costs a little more than a CPI-U adjusted one

Post by #Cruncher »

The Internal Rate of Return (IRR) [1] is low for all three. But, in my opinion, it is worst for the CPI-indexed annuity.

Code: Select all

   Type         Cost      IRR
------------   -------   -----
Fixed          186,075    2.1%  $1,000/mo
3% Increase    258,796    2.0%  $1,000/mo yr 1, $1,030/mo yr 2, $1,060.90/mo yr 3, etc. [2]
CPI Indexed    251,347   -0.6%   1,000/mo real $
One has to accept a yield 2.7% points less (-0.6% vs 2.1%) to have the annuity CPI-indexed. While CPI-indexation is a good idea in general, this seems like too high a price to pay. For example, to get the CPI-indexation of TIPS, one has to only accept a yield about 1.6% points less than nominal Treasuries. (0.33% vs 1.89% and 0.94% vs 2.66% for 10-year and 30-year bonds according to Treasury real yields and nominal yields.)
  1. To compute the 2.1% and -0.6% IRRs I used this longevity estimator with the SSA 2011 Period Life Table for a 66 year old female. 2.1% is the discount rate that makes the survival-weighted $1,000 / month have a present value of $186,075. -0.6% is the discount rate that makes the same survival-weighted $1,000 / month have a present value of $251,347.
  2. To compute the IRR for the 3% Increase case, on a separate spreadsheet I increased the survival-weighted $1,000 / month figures from the longevity estimator by 3% each year beginning the 2nd year. 2.0% is the discount rate that makes this cash flow have a present value of $258,796. Since its 2.0% IRR is almost as high as the 2.1% of the fixed annuity, it would be a better choice to guard against living longer than average.
Bill M
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Re: 3% annuity costs a little more than a CPI-U adjusted one

Post by Bill M »

I'd certainly go for CPI-U.
Further, I'd guess that anyone who has been investing since the 1970s would also go for CPI-U, while anyone who started investing in the 1990s wouldn't. Since about 1992 annual inflation has stayed around 3%, while in the late 1970s it hit 14%/yr. That 14% still scares me (even the possibility of it), and is worth some "insurance".
protagonist
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Re: 3% annuity costs a little more than a CPI-U adjusted one

Post by protagonist »

CPI-U hands-down.

The purpose of an annuity is wealth preservation and security.

The future is unknown. A few years of double-digit inflation like in the late 70s/early 80s (my first mortgage-fixed- in 1983 was at 13%) could be catastrophic to a 3% annuity.

And of course it can happen again, any time.
randomguy
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Re: 3% annuity costs a little more than a CPI-U adjusted one

Post by randomguy »

#Cruncher wrote:The Internal Rate of Return (IRR) [1] is low for all three. But, in my opinion, it is worst for the CPI-indexed annuity.

Code: Select all

   Type         Cost      IRR
------------   -------   -----
Fixed          186,075    2.1%  $1,000/mo
3% Increase    258,796    2.0%  $1,000/mo yr 1, $1,030/mo yr 2, $1,060.90/mo yr 3, etc. [2]
CPI Indexed    251,347   -0.6%   1,000/mo real $
One has to accept a yield 2.7% points less (-0.6% vs 2.1%) to have the annuity CPI-indexed. While CPI-indexation is a good idea in general, this seems like too high a price to pay. For example, to get the CPI-indexation of TIPS, one has to only accept a yield about 1.6% points less than nominal Treasuries. (0.33% vs 1.89% and 0.94% vs 2.66% for 10-year and 30-year bonds according to Treasury real yields and nominal yields.)
  1. To compute the 2.1% and -0.6% IRRs I used this longevity estimator with the SSA 2011 Period Life Table for a 66 year old female. 2.1% is the discount rate that makes the survival-weighted $1,000 / month have a present value of $186,075. -0.6% is the discount rate that makes the same survival-weighted $1,000 / month have a present value of $251,347.
  2. To compute the IRR for the 3% Increase case, on a separate spreadsheet I increased the survival-weighted $1,000 / month figures from the longevity estimator by 3% each year beginning the 2nd year. 2.0% is the discount rate that makes this cash flow have a present value of $258,796. Since its 2.0% IRR is almost as high as the 2.1% of the fixed annuity, it would be a better choice to guard against living longer than average.

That CPI math is making the assumption of 0% inflation over the lifetime of the annuity. That doesn't seem very realistic.. Throw in that adjustment (say assume 2% inflation) and the IRR will go up. It should still be less than the other 2 as you are paying money for inflation protection. Throw in a decade of 7% inflation, and the CPI one will look great compared to the other two. Odds are you will not get that inflation but that is true of any insurance product.
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Frugal Al
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Re: 3% annuity costs a little more than a CPI-U adjusted one

Post by Frugal Al »

I think what Cruncher saying is that TIPS are a more efficient inflation hedge than the CPI-U indexed annuity. Not only that, but TIPS are not irrevocable, as is the annuity funding. Also, the U.S. Treasury offers lower risk than an insurance company, when the bad stuff hits the fan. Given those reasons, I think I'd go with the nominal annuity and supplement with TIPS. While not as convenient as the inflation indexed annuity, in my opinion the lower cost and the benefits outweigh the inconvenience.
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Re: 3% annuity costs a little more than a CPI-U adjusted one

Post by randomguy »

Frugal Al wrote:I think what Cruncher saying is that TIPS are a more efficient inflation hedge than the CPI-U indexed annuity. Not only that, but TIPS are not irrevocable, as is the annuity funding. Also, the U.S. Treasury offers lower risk than an insurance company, when the bad stuff hits the fan. Given those reasons, I think I'd go with the nominal annuity and supplement with TIPS. While not as convenient as the inflation indexed annuity, in my opinion the lower cost and the benefits outweigh the inconvenience.
You end up with a different product. Run the math on what happens if you buy the nominal annuity, invest the rest in TIPS, and spend real dollars. About 20 years in, you will have spend all the tips money and you will be left with just the nominal annuity income. It is like saying why get 2.1% from the annuity when you can get 2.66% from 30 year bonds:)
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Re: 3% annuity costs a little more than a CPI-U adjusted one

Post by longinvest »

#Cruncher wrote:The Internal Rate of Return (IRR) [1] is low for all three. But, in my opinion, it is worst for the CPI-indexed annuity.

Code: Select all

   Type         Cost      IRR
------------   -------   -----
Fixed          186,075    2.1%  $1,000/mo
3% Increase    258,796    2.0%  $1,000/mo yr 1, $1,030/mo yr 2, $1,060.90/mo yr 3, etc. [2]
CPI Indexed    251,347   -0.6%   1,000/mo real $
One has to accept a yield 2.7% points less (-0.6% vs 2.1%) to have the annuity CPI-indexed. While CPI-indexation is a good idea in general, this seems like too high a price to pay. For example, to get the CPI-indexation of TIPS, one has to only accept a yield about 1.6% points less than nominal Treasuries. (0.33% vs 1.89% and 0.94% vs 2.66% for 10-year and 30-year bonds according to Treasury real yields and nominal yields.)
#Cruncher,

While I agree with your calculations, I disagree with your conclusions. In my view, the difference in spreads between nominal and CPI-indexed SPIAs (2.1% - -0.6% = 2.7%), versus 30-year nominal bonds and TIPS (2.66% - 0.94% = 1.72%) represents the cost of insurance for a worry-free retirement, in face of unknown future inflation, far away in the future, in case of higher-than-average longevity.

If the spread between nominal and CPI-indexed SPIAs had been 1.7% instead of 2.7%, the CPI-indexed SPIA would have cost $216,605*. In other words, the cost of this insurance is $34,742 (which represents 16% of $216,605).

* My calculation might not be accurate, but it should give a ballpark estimate.

Is this insurance worth it, at that cost? That's up to the retiree to decide.
Last edited by longinvest on Tue Mar 29, 2016 10:47 am, edited 3 times in total.
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Re: 3% annuity costs a little more than a CPI-U adjusted one

Post by nisiprius »

When I was faced with that choice, I opted for the CPI-U adjusted annuity.

It wasn't based on any sophisticated analysis of the best deal. Since the 3%-compound-increasing annuity's cost was in the same ballpark as the CPI-U indexed annuity, and since the average inflation since 1913 has been around 3%, and has also been around 3% since Volcker squeezed it down, I concluded that there wasn't anything particularly awful about the CPI-U. As with the 3%-compound-increasing annuity, it costs a lot more than the flat annuity because in all likelihood it's going to be paying out a lot more. The fact that the two numbers were in the same ballpark, and that the two insurance companies offering such annuities had premiums in the same ballpark, convinced me that it was all competitive and all comparable.

I opted for the CPI-U adjusted annuity based on what I wanted to achieve. It was a risk-reduction strategy, and trying to guess future inflation is a risk I didn't want to take. I'd rather pay the insurance company in order to have them take that risk.

Having lived through the 1970s and 1980s I didn't want to experience what can happen to flat payments in an era of high inflation. I was also influenced by my mom's sad tale of how my dad's mom made him a "gift" of a kind of whole life policy, called an "endowment policy," and how they had to pay premiums on it all through the Depression years when money was hard to come by, only to have it mature just after World War II when inflation had cut its value in half.

In short, the difference between "what inflation actually is" and "guessing it will be 3%" was important enough to me that I didn't try to get too precise on "which is the better value."
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castlemodesto
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Re: 3% annuity costs a little more than a CPI-U adjusted one

Post by castlemodesto »

It all depends on the "big picture. A nominal will probably provide the most real income for while you are both alive. But do you have a "plan B" for your wife as survivor at eg 80 or 85 if inflation has been high. If you have a backup plan such as using a reverse mortgage as your "insurance policy" then it may be worth "insuring" yourself instead of "paying" for the CPI "insurance policy".
A 19 year TIPS ladder and then DIA for age 85 is another option (again if you have a contingency plan if inflation is higher than what you guessed for inflation at age 85)
"playing the odds" is ok if you have alternatives (such as using other assets that would otherwise have gone as a legacy). If you dont have a contingency plan that you are comfortable with, then you probably need to pay the "insurance" price of CPI.
bigred77
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Re: 3% annuity costs a little more than a CPI-U adjusted one

Post by bigred77 »

I think for me it would depend on how large a chunk of my portfolio I was considering annuitizing.

If I was using 50% or more of my investable assets, I would opt for the CPI-U adjusted product.

if I was using 15%-25% of my investable assets, I would use the fixed, nominal product and adjust my remaining portfolio to increase inflation protection (at least 50% of my fixed income would be in TIPS).

I agree with others that I would forgo the annuity with annual 3% increases. That is a taking a position on future inflation. I view annuities as a risk reduction tool and this particular flavor does not optimize risk reduction.
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Why it is usually better to wait until about 80 before purchasing a SPIA

Post by Taylor Larimore »

peter_s wrote:While revisiting the idea of using annuities in our financial plans, I obtained the following quotes this evening for a $1000/month single life annuity from AIG through the Vanguard hosted Income Solutions site, for my wife, age 66:

1000/month fixed: 186,075 (6.4%)
1000/month, with 3% annual increase compounded per year: 258,796 (4.6%)
1000/month, CPI-U adjusted upward: 251,347 (4.8%)

Which one would you choose (if you were choosing)?
Peter:

I would not choose now. I think you should probably put-off purchasing a lifetime annuity (SPIA) until your late 70's or early 80s. There are many reasons:

* Inflation is less important so the cost of an "inflation-rider" may be avoided.
* The cash premium might be needed for an emergency.
* In the event of early death the annuity is not needed.
* If your portfolio exceeds expectations, a SPIA might no longer be desired.
* At older ages the premium is lower or life-income larger.
* Premiums, based on current low interest rates, might be lower.
* In the event of a disease or illness reducing life-expectancy, a SPIA would probably be a bad purchase.
* Less time for the insurance company to get in trouble.

This study concludes it is usually better to wait until the purchaser is around 80 before purchasing a SPIA:

Breakeven Comparison

Best wishes.
Taylor
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longinvest
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Re: Why I think it is usually better to wait until about 80 before purchasing a SPIA

Post by longinvest »

Taylor Larimore wrote:I would not choose now. I think you should probably put-off purchasing a lifetime annuity (SPIA) until your late 70's or early 80s.
I completely agree. I would also delay Social Security until 70; that's the cheapest inflation-adjusted annuity available.
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Re: 3% annuity costs a little more than a CPI-U adjusted one

Post by garlandwhizzer »

Taylor wrote:


I would not choose now. I think you should probably put-off purchasing a lifetime annuity (SPIA) until your late 70's or early 80s. There are many reasons:

* Inflation is less important so the cost of an "inflation-rider" may be avoided.
* The cash premium might be needed for an emergency.
* In the event of early death the annuity is not needed.
* If your portfolio exceeds expectations, a SPIA might no longer be desired.
* At older ages the premium is lower or life-income larger.
* Premiums, based on current low interest rates, might be lower.
* In the event of a disease or illness reducing life-expectancy, a SPIA would probably be a bad purchase.
* Less time for the insurance company to get in trouble.
This in my opinion is annuity wisdom in a nutshell. The longer one defers buying an annuity the better the numbers work. The major risk you have to keep your eye on is loss of mental competence to make sound financial decisions. As long as you're competent to handle your assets, deferring annuity purchase is a good idea. If you're reading and understanding this forum board every day it is highly unlikely that you have lost that mental competence.

Garland Whizzer
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Re: 3% annuity costs a little more than a CPI-U adjusted one

Post by randomguy »

garlandwhizzer wrote:
Taylor wrote:


I would not choose now. I think you should probably put-off purchasing a lifetime annuity (SPIA) until your late 70's or early 80s. There are many reasons:

* Inflation is less important so the cost of an "inflation-rider" may be avoided.
* The cash premium might be needed for an emergency.
* In the event of early death the annuity is not needed.
* If your portfolio exceeds expectations, a SPIA might no longer be desired.
* At older ages the premium is lower or life-income larger.
* Premiums, based on current low interest rates, might be lower.
* In the event of a disease or illness reducing life-expectancy, a SPIA would probably be a bad purchase.
* Less time for the insurance company to get in trouble.
This in my opinion is annuity wisdom in a nutshell. The longer one defers buying an annuity the better the numbers work. The major risk you have to keep your eye on is loss of mental competence to make sound financial decisions. As long as you're competent to handle your assets, deferring annuity purchase is a good idea. If you're reading and understanding this forum board every day it is highly unlikely that you have lost that mental competence.

Garland Whizzer
Isn't the question though how often things don't work out with the investing approach? What are your chances of having enough money at 66 to buy the inflation adjusted annuity but not having enough at 80 (due to portfolio loses, lower payouts,...)? Obviously investing is expected to have much better returns (i.e. you are not paying the insurance company) for all but the bottom 5-10% cases. But if you are losing sleep over those 5% cases, you need to know what happens if you happen to retire into one of those cases.

As far as not needing inflation protection, that is a toss up. If that 80 year old makes it to 95, the might be a bit bummed to have had their income cut by 30% over that time period (i.e about what you get with our low inflation. Something like the 70s would be more like 70%).
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Re: 3% annuity costs a little more than a CPI-U adjusted one

Post by Johno »

randomguy wrote:
#Cruncher wrote:The Internal Rate of Return (IRR) [1] is low for all three. But, in my opinion, it is worst for the CPI-indexed annuity.

Code: Select all

   Type         Cost      IRR
------------   -------   -----
Fixed          186,075    2.1%  $1,000/mo
3% Increase    258,796    2.0%  $1,000/mo yr 1, $1,030/mo yr 2, $1,060.90/mo yr 3, etc. [2]
CPI Indexed    251,347   -0.6%   1,000/mo real $
One has to accept a yield 2.7% points less (-0.6% vs 2.1%) to have the annuity CPI-indexed. While CPI-indexation is a good idea in general, this seems like too high a price to pay.

That CPI math is making the assumption of 0% inflation over the lifetime of the annuity. That doesn't seem very realistic.. Throw in that adjustment (say assume 2% inflation) and the IRR will go up.
I agree, I quickly ran the calculation and as given it's implicitly embedding the assumption that inflation is zero. If instead you project the cash flows of the CPI adjusted annuity based on the TIPS BE inflation rate, 1.77% in 30 yrs, the IRR's come out more like 1% different. At 2.84% inflation they'd be the same.

But IRR is often misleading. It may be better to simply discount the cashflows at a common nominal rate, after projecting the CPI adjusted ones at a given inflation rate, and compare the calculated Present Value to the price of each. With a nominal rate of 2.61% (today's 30 yr bond yield) and 1.77% inflation (today's 30 yr nominal minus TIPS breakeven) the PV of the fixed annuity (I won't bother with the 3% fixed escalation one) is $170,274, whereas they charge you $186,075. The PV of the inflation adjusted annuity is $202,681 but they charge $251,347. So there's an extra margin of $32,865 for the ins co in the CPI adjusted price relative to the 30 yr govt bond nominal/TIPS relationship. It's probably some combination of them assuming a higher inflation rate relative to the nominal rate (as compared to TIPS breakeven), a higher uncertainty for the company to actually hedge that risk in reality, and just less competition for CPI adjusted annuities.
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