Evaluating an Immediate Annuity
Henry K. Hebeler
I recently looked into buying an immediate annuity for my wife. To help make the decision, I used the free program for this purpose on www.analyzenow.com because evaluating an immediate annuity is often far from a simple task. I looked at two situations: (1) The funds would come from a tax-free money market in my taxable accounts, or (2) funds would come from my 401(k). The latter would require that I make a 1035 tax-free exchange from the 401(k) and then to an IRA from which I could transfer the money to a deferred-tax immediate annuity without incurring tax on the transfer.
Results if use a taxable account:
I completed the input section of the program as shown below. Note that I did not check either of the source boxes for this case. Also, I input 67% for the survivor’s spending needs and used the same percentage for the survivor rate for the annuity quotes, but these need not be the same percentages.
Step 4 requires that I input quotes for whatever kind of immediate annuity I want. I decided to input quotes for all three types the program will accept. I used www.vanguard.com quotes for my inputs based on my wife’s and my birth date.
For Step 5, I used the Control Panel. It’s best to look at today’s dollar values in an analysis of this kind so as not to be deceived by the effects of inflation.
The next decision to face in the Control Panel is the kind of scenario I want to use for the initial period and what I think may happen later (Thereafter) in our retirement. I believe inflation will increase, particularly since our medical bills will increase as we age. For investment returns I used a comparable return to my fixed investments because this would replace some of that part of my portfolio. Since my tax-exempt money markets were yielding around 3.5% at that time, I entered a return of 3.5% / (1.0 – 35%) = 5.4% (rounded) for a before-tax return. In the Thereafter, I assumed a significantly long period of poor results as the nation gets higher taxes from fewer workers per retired people and less consumption as people recognize they have to start saving more.
Then I guessed at what could easily happen to tax rates for higher income people.
In addition to the year the economic change will take place, the control panel allows me to select the year of the owner’s death. Since the results vary depending on my wife’s death age, I chose to look at three cases: (1) She dies at 95, (2) she dies at 90 (approximately her age at our joint and last survivor life-expectancy), and (3) she dies prematurely at 75.
Taxable immediate annuity if annuitant dies at 90:
We’ll first look at the nominal case for my wife’s death at 90. The associated values in the Control Panel are shown below:
After all of the inputs above, the after-tax annual annuity income is displayed in the chart below:
Figure 1. The after-tax payments from a taxable immediate annuity can have a lot of ups and downs. That makes them difficult to analyze. This pattern represents what happens when the owner dies at 90 and the survivor gets 67% of the owner’s payment values.
Most remarkable are all of the changes that take place in after-tax annuity payments shown in Figure 1. They are affected by changes in tax rates (at 10 years), loss of the tax exclusion (at age 88), and death (at 90). People think of immediate annuities as simple investments, but they are not easy to evaluate.
Before being able to see the amount left in Investment Balances and what happens to spending, we have to select an after-tax spending level for the first year. This we do in the Control Panel as shown below:
I chose to use a nominal value of $4,975 because if my wife didn’t buy the annuity, that’s the value that would provide the same inflation adjusted spending until age 91, slightly over our joint and last survivor life-expectancy. (The slider controls in the control panel make it easy to see the effects from changing the spending level and most other values.)
The investment balances chart taken from the program and displayed in Figure 2 shows how much would be left in an account for each of the four alternatives:
Figure 2. The after-tax investment balances all disappear at age 90 for the particular spending level selected anticipating a death at age 90.
Now comes the most interesting part to me. That’s the amount that we can afford to spend on an after-tax basis for each of the scenarios. The results for all of the values selected above are displayed in today’s dollars in Figure 3.
Figure 3. The after-tax spending is sustained by the annuities when the investments are exhausted at age 90 in this case where the annuity was purchased with funds from taxable accounts.
The chart illustrates the benefit of immediate annuities. They provide some spending capability late in life. That’s why they are an insurance product. Because I expect inflation to be higher than normal in late years, the immediate annuity with a full COLA is the best choice, followed by one with 3% automatic increase each year, and finally the fixed payment immediate annuity.
Evaluating a taxable immediate annuity if owner dies prematurely:
The chart in Figure 4 shows the complexity if my wife dies prematurely at age 75. The first drop is a consequence of the fact that I believe I could live on 67% of our income after my wife dies should I survive her. The other drops are a consequence of increased taxes, exhausting investments and using up the tax exclusions. Since the final drops are beyond when I would likely live, there is not much difference from my standpoint whether she gets an annuity or not, especially since if she doesn’t, I could buy one after her death that would provide significantly more income—providing that I was not yet 85 or whatever will be the maximum age to purchase an immediate annuity. Remember, the horizontal axis is in terms of her age because she would own the annuity, but my own age is three years more.
Figure 4. After-tax spending drops abruptly if my wife would die prematurely at 75, but the taxable immediate annuities would provide some income after her age of 95 or, equivalently, my age of 98.
Evaluating a taxable immediate annuity if owner is long-lived:
For us, the final case is perhaps the most important. This is when my wife’s death at 95 (my age 98) is later than our joint and last survivor life-expectancy of about 90 for my wife or 93 for me. We both have a reasonable chance of linving longer than those life expectancies because we both have relatives that have died in their late nineties and we are in good health. This case is illustrated in Figure 5. Again these are all today’s dollar values.
Figure 5. Once the investments are exhausted, the income, if any, comes from the taxable immediate annuities. If no annuity, there would be no income after age 90.
The immediate annuity with the full COLA is the best choice for this region of our expected deaths. Remember that these conclusions are based on my assumptions about the future and buying the investments in taxable accounts. Let’s look next at buying an immediate annuity in a deferred-tax account using the same assumptions about the future.
Results if use a tax-deferred account:
Now I have to check the box indicating that I’ll use a deferred-tax account as a source of funds to buy the annuity.
The only other input differences from the taxable account are the initial investment balance and the resulting annuity payments. I’m in the 35% tax bracket, so in order to make after-tax spending comparable to the $100,000 taxable investment case, I have to use $100,000 / (1.0 – 35%) = $153,846 for the investment entry. I will not have a penalty for making this tax-free transfer from my 401(k) to an IRA and then to the immediate annuity.
Step 3 has the same age and survivor’s percentage, but the values in Step 4 increase in proportion to the higher investments, and there is no exclusion in a deferred-tax account.
Using a death age of 95, the after-tax annuity payments are shown in Figure 6. The drops in payments come from increased taxes in the 10th year of the scenario and the switch to survivor’s benefits at my wife’s age of 95.
Figure 6. The after-tax income from the deferred-tax annuities does not have the drop from exhausting the exclusions of taxable annuities.
The corresponding investment balances displayed in Figure 7 are also on an after-tax basis and assume that the account would be liquidated at whatever is the prevailing tax rate at the time. That’s the reason for the kink in the No Annuity curve in the 10th year.
We can see the final results in Figure 8 for the after-tax annual spending in today’s dollar values. As with the annuities from a taxable account, the annuity provides some income after other investments are exhausted.
Figure 7. The after-tax investment balances in deferred-tax accounts have a kink from the increased tax rate ten years out.
Figure 8. As with taxable accounts, deferred-tax immediate annuities provide income after investments are exhausted. But the results are slightly more attractive than the taxable account results in Figure 3. Both assume an annuitants death at 95.
Using deferred-tax accounts is slightly better than using taxable accounts as the source of the annuity money providing the purchase can be done on a tax-free basis. For the future, as I perceive it, an immediate annuity with full COLA provisions would be best.
Immediate annuity benefits increase when you purchase them at older ages (because the insurer will have fewer years to pay), and they increase when interest rates are higher (when the insurer is forced by competition to offer lower investment costs to provide the same level of payments). We have not yet reached the point where we are dependent on anyone to handle our finances for us; we are still relatively young retirees; and interest rates are below long-term historical values. Therefore, we do not have a compelling reason to get into an immediate annuity at this time.
Ultimately, I expect that we might employ immediate annuities for part of our income because they require no management effort, provide a steady stream of income no matter how long we live, and may reduce our estate tax. From that standpoint, the better source is likely to be our deferred-tax accounts because it would be good to reduce such accounts shortly before death so that our heirs won’t have to pay both estate tax and income taxes on those accounts. The net result is likely to be higher income for us and less for the IRS—unless the IRS changes the rules significantly—again!
Note: The IRS makes money on early deaths with immediate annuities in non-qualified accounts because it’s unlikely that people will go back and try to retrieve the excess income tax that was collected. In such cases, annuity owners effectively paid income tax on the return of their principal. In most instances, the legal and accounting costs of retrieving those overpaid taxes would cost more than the tax refund.