The era of ultra-low interest rates continues and from comments being made by the Federal Reserve Board of Governors, it may be with us for several more years. The result is that investors who wish to remain risk averse and use traditional savings vehicles like certificates of deposit or money market funds continue to earn little return on their capital.
Of course, brokerage firms and insurance companies do their best to promote products which appeal to these investors’ emotions of fear and greed. One of these vehicles, which looks pretty attractive in print advertising in our current low interest rate environment is the “immediate annuity."
An immediate annuity is one that is annuitized at the moment it is purchased. When an annuity is annuitized it means that the owner is exchanging their investment capital for a promise of future monthly payments. These payments may be for a particular period of time, say five, 10 or 15 years, or can be structured to last for the rest of your life, or even based on two lives.
Rates vary from company to company, but are mostly influenced by the owner’s age and, as mentioned above, the period of time you would like to receive the payments. When comparing immediate annuities it is important to understand how the payment rates are expressed. There is the annual payout rate which is the total of the monthly payments for one year divided by the amount you invested in the annuity.
For example, a 70-year-old male could put $100,000 into an immediate annuity today with a 15-year payment period and receive about $670 per month, with his beneficiaries continuing to receive the payments if he should die before the 15-year period is over. The annual payout rate from receiving $670 per month from a $100,000 investment is 8.04 percent, or $8,040.
8.04 percent sounds spectacular in our current environment of sub-one percent CD rates, but it is very important to understand that, unlike a maturing CD, you (or your heirs) don’t get your $100,000 investment back at the end of the payout period. If you collect the monthly payments for the whole 15 years in our example, you will receive a total of $120,600. Your real “profit” would be the $20,600 above and beyond the initial investment, and this figure should be used to assess your true rate of return.
$20,600 profit over a period of 15 years on a $100,000 investment is less than 1.5 percent per year. This is not much reward for losing access to your investment capital and having to pay tax on the annuity income as well. Higher rates may be possible if you were willing to not protect your spouse or heirs. In other words, you could receive a higher monthly payment, but if you die half way through the payout period, your heirs would not receive the balance of the payments and the insurance company still keeps your original investment.
Immediate annuities serve a purpose in certain situations, particularly where the investors needs a high level of guarantee of a particular amount of income over a period of time. However, beware of being lured by the idea of the annual payout rate which could be in the 7-10 percent range. Make sure to find out the internal rate of return being used to calculate your payments and make your decision based on that.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing. Visit www.breitercapital.com.