In my last post, I referenced a Q & A with Money Magazine’s Walter Updegrave. This was the question:

I’m planning to retire in about a year when I’m 62. My company pension plan offers me the option of taking a lump sum of about \$775,000 or a monthly annuity payment of \$3,600 that would go to me or my wife as long as either of us is still alive. I also have another \$500,000 invested in a 401(k) and in IRAs. I’m undecided about whether to take the lump sum or the annuity. I’m also wondering whether I could get a higher monthly payment if I took the \$775,000 lump sum and bought an income annuity. I’d appreciate your advice on this.

From my analysis, the annuity payment of \$3,600 per month does not seem like that great of a deal. Oh sure, you get the warm and fuzzies knowing that every month you will get a check for \$3,600. However, those warm and fuzzies come at a pretty high cost. There’s two problems with this particular annuity:

1. On an annual basis, the monthly payment of \$3,600 works out to around 5.57% of the original prinicipal of \$775,000:

\$3,600 X 12 = \$43,200

\$43,200 ÷ \$775,000 = .0557 or 5.57%

This doesn’t sound bad at the outset. However, this 5.57%, or \$43,200, is constant because the \$775,000 will never increase in value. There’s also the slight risk that he and his spouse might die early, which would mean that the income would end and the “balance” would be lost. According to my math, it would take 18 years before this person’s rate of return would turn positive. To figure this out, I did some analysis using the XIRR function in Microsoft Excel. Here’s what I came up with:

As you can see from the spreadsheet, the XIRR, which is a form of Internal Rate of Return, improves with each year. That’s because with each year, this person is getting back a little more of the original \$775,000. The right hand column is the running XIRR. In other words, if the couple were to die at the end of year 10, their XIRR would be -11.07% for that period. And this number is BEFORE we factor in inflation, which leads us to problem number 2:

2. Inflation will eat away at the purchasing power so that within 15 years, the annuity payment will be worth about half what it is today and that’s figuring a relatively low inflation rate of 3.50%. Take a look at this chart:

Now look at the Inflation-Adjusted XIRR calculation:

Looks kind of scary, doesn’t it? I’m sure this couple could find a better Immediate Fixed Annuity if they did some research. Regardless, I don’t think I would stick all \$775,000 in an annuity. Rather, I would set aside a portion for the annuity and invest the rest.

In the future, I want to look at what are the alternatives to Immediate Fixed Annuities.

### 9 responses to The “Risk” With Fixed Immediate Annuities

1. JLP
Thanks for the IRR calculation. I read the same article and and been trying to understand the IRR. Looks like you’re very familiar with Excel and some of it’s tools. Really helpful for annuity calculations. Despite some of the return calculations..I think immediate annuities may be valuable for investors who are not covered by pensions (probably about 80% of us now) and who really have longevity in their families.
Thanks for the information!
Nancy http://www.retirementthink.com

2. the reader should also be looking into the next generation of for life living benefits offered on a variable annuity. you get the same for life paycheck for both husb and wife without annuitizing. once they both pass away, whatever is left as the death bene goes to the benficiary. if they dont need income right away they can defer taking wd’s and get growth on their investment. also the money would be in the market, so if the market performs well they can lock in gains each year to keep pace with inflation.

they should definitely give them a look, each company varies, so ask your financial planner which ones they use. if they don’t, ask your FP to ask his back office for what companies they prefer.

3. I RECEIVED A SETTLEMENT FROM A CAR ACCIDENT AND MY LAWYER CONVINCED ME TO PUT SOME OF IT IN TO A ANNUITY. I DIDN’T WANT A FIXED IMMEDIATE ANNUITY AND I ASKED HIM IF I COULD EVER GET THIS MONEY OUT AND HE SAID YES , BUT I WOULD HAVE TO PAY A PENALTY. I CALLED METLIFE THE OTHER DAY AND THEY SAID THAT I COULD NOT GET MY MONEY. THE ONLY MONEY I CAN GET IS WHAT I GET PAYED EACH MONTH NOW. I WANT MY MONEY OUT OF THIS COMPANY AND I WANT TO KNOW HOW I CAN DO IT. I WAS INCORRECTLY INFORMED ON THIS, AND I DONT WANT TO SELL IT TO ONE OF THESE COMPANYS THAT WOULD KEEP ALL MY MONEY AND I GET NOTHING. I NEED SOME HELP PLEASE. I LOOK FORWARD TO HEARING BACK ON THIS. THANK YOU

SINCERELY,
MARY

4. I am in the same boat. I want to sell mine too and I know I will lose a lot but does anyone have suggestions on how to go about this? Fixed Immediate Annuity is the name of mine.

Thank you,

Kelly

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