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“The wise man bridges the gap by laying out the path by means of which he can get from where he is to where he wants to go.” — j.p. morgan

Today fewer employers are offering defined benefit plans to their employees.  As an alternative retirees are purchasing annuities that would provide them with a steady stream of income into their retirement years.  Insurance companies have responded to the retiree’s needs with various annuity products.  In recent years annuities continue to grow in popularity.  According to LIMRA, the Windsor, CT-based financial services research firm, the sale of all annuity products reached $122.4 billion for the six months through 6/30/2011, an increase of 13% (a).

What are types of annuity?

Annuities can be segregated into variable annuities and fixed annuities.  With fixed annuities the investors are offered a lower return as the insurance companies assume the investment risk.  With variable annuities the investors assume the risk an can invest in a variety of investments with the expectation of achieving superior returns.

Fixed annuities provide guaranteed regular payments to the policyholder over the term of the contract.  These contracts can either start immediately or deferred to a future date.  Retirees are using annuity payouts to supplement Social Security and cover basic expenses.

Advantages and disadvantages?

With a deferred annuity the investor lose control of his assets once he hands over the money to the insurance company.  Should the investor change his mind there could be substantial surrender charges.

With an immediate annuity the investor give up control of his money.  Most immediate annuity provide the investor with income for life.  Once the investor dies, nothing is left to the heirs.

There are immediate annuities that can provide income to heirs.  Such policies are more expensive resulting in a smaller income to the investor during his lifetime.

Create your own Fixed Annuities.

To save on high commission fees, you can create your own fixed annuities.

In the charts below are example computations using an initial investment of $100,000.  I used the 10 year Treasurys for investment in the fixed income portion.  This instrument currently pays an annual yield of 2.5% (b).  I use the SPY ETF to mimic investment in the S&P 500.

In exhibit A, I allocated $79,250 to 10 year Treasurys with the balance going to the SPY ETF.  Should the market declines 13% per year (twice the gain of 6.7%), the investor have protected his initial investment after 5 years.  Should the market stay flat the investor’s $100k investment grows by 10.4% to $110,414.  Should the market increase by 6.7% per year (c) the investor’s $100k investment grows by 18.4% to $118,361.  In the three scenarios, the Treasurys provide a guaranteed return.  And you, the investor, maintains the assets, not the insurance company,

In exhibit B, I show a 100% allocation to 10 year Treasurys.  If the investor can achieve a rate of 2.63% for the 20 year investment period, he should be able to withdrawal $6,414 per year over twenty years.

Should you buy a fixed income annuity or should you create your own fixed annuity?  Call us at 415.967.EDGE or e-mail us at paulsid@financialedge.net today and let us crunch out the answer for you.

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References:
(a) http://www.financial-planning.com/news/variable-annuity-sales-surge-second-quarter-2674713-1.html?portal=annuities&id=2674713&sponsor_info=1238
(b) http://www.bankrate.com/rates/interest-rates/10-year-treasury-bill.aspx
(c) http://seekingalpha.com/article/270171-jeremy-siegel-finds-stocks-currently-fair-to-undervalued-is-he-right