By Kevin P. Brosious, CPA, PFS, CFP

I recently read a financial blog written by a 64-year-old man who purchased a three-year deferred income annuity that he claims guarantees him an annual 8.3% rate of return for the rest of his life. He is retiring in three years and wanted another form of guaranteed income to supplement his Social Security retirement benefits. He made a single premium payment of $300,000 for the annuity, and after a three-year deferral period, he will receive about $25,000 each year for the rest of his life. His annuity includes a death benefit rider that guarantees his heirs a lump sum payment equal to the remaining premium that has not yet been disbursed to him. He thought the annuity purchase would be a good idea since his mother and father both lived into their 90s.

This gentleman’s claim of an 8.3% return for the rest of his life intrigued me, so I calculated the internal rate of return (IRR) for his investment. The IRR provides the average annual rate of return he can expect to receive from the annuity over his lifetime by considering the amount and timing of all his cash flows. Of course, with any annuity contract your return depends upon how long you live. The Social Security Life Expectancy Calculator estimates that the average life expectancy for a 64-year-old man is 20 years (to age 84). That’s a good place to start.

One key consideration is that he won’t make a return on his investment for quite some time. By dividing his initial $300,000 investment by his promised annual income of $25,000, we find that it will take 12 years just to recover his premium. Add three years of deferral and he won’t be making any return on his investment until 15 years after purchasing the annuity.

You can easily calculate the IRR with an online calculator (such as the one found at CalculateStuff.com) or by using the IRR function on a financial calculator or the XIRR function on an Excel spreadsheet. Assuming he lives until his full life expectancy of 84 years, his return would be 3%. If he lives to age 90 his return would increase to 4.8%; at 92 it would rise to 5.1%. These numbers are quite different than his claim of an 8.3% return. In fact, he wouldn’t realize an 8.3% return even if he lived to 120.

The 8.3% he referenced is the payout or distribution rate, not the rate of return on his investment. The payout rate is his annual distribution (post deferral) of $25,000 divided by his initial $300,000 investment. The payout rate, however, includes both interest and a return of his invested principal.

But what if this man happens to die younger than his life expectancy? How does the $300,000 guaranteed death benefit affect his return? If he should die in 15 years, at age 79, his return would be zero, and he would realize a zero return if he died in any year prior to his 79th birthday because the death benefit would make up the difference between the sum of the payouts he received and his initial investment.

Even though this man will never achieve an 8.3% return, would an annuity still be a good investment for him? Since both his parents lived a long life, I think it is appropriate for him to consider an additional stream of guaranteed income that will last his lifetime. The main reason to buy annuities is to protect you from outliving your money, and a lifetime annuity will do just that.

That said, his payout seemed a bit low compared to other annuities from highly rated insurers I discovered that offer the same guarantees.¹ Annuity terms and rates of return may vary considerably between insurance companies, so investors and their advisers should investigate several annuities before purchasing. Also, calculating your IRR can be a tremendous help in deciding which fixed annuity is appropriate for you. All annuity investors should also understand that a “guarantee” to pay depends upon the issuing insurance company’s ability to pay, so consider highly rated, financially sound insurers.²

¹ You can get online annuity quotes and compare payouts without having to speak to a sales representative by going to www.immediateannuities.com.
² The Pennsylvania Life and Health Insurance Guaranty Association will provide some protection to any Pennsylvania resident who realizes losses from annuities purchased from an insurer that was authorized or licensed to do business in Pennsylvania.

Kevin P. Brosious, CPA, PFS, CFP, a consultant for Newbridge Wealth Management in Bryn Mawr, Pa. He can be reached at kevin@wealthmanagement1.com.

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^{Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of the PICPA's officers or members. The information contained herein does not constitute accounting, legal, or professional advice. For actionable advice, you must engage or consult with a qualified professional.}