Immediate Fixed Annuities Part 2 – Immediate Fixed Annuities – The Hidden Risks

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Immediate Fixed Annuities Part 2 - Immediate Fixed Annuities - The Hidden RisksIf it sounds too good to be true, it is. Either trust this maxim or else learn the hard way. For example, fixed annuities…

Last week we analyzed the return on a $500,000 immediate fixed annuity sold to the Jeffersons, a couple aged 64 (Thomas) and 62 (Martha). The annuity paid $35,000 per year, and then reduced to $23,333 after the death of one spouse. It looked like a guaranteed 7% return. It was not.

If Tom and Martha died any time during the first 14 years, their return would be zero; they would only have received their own money back. Assuming they lived average life spans, their return would be 3.06%, and even if they both lived to be 100, their annual return could only reach 6.35%.

These are not very impressive returns. This week we will look at the additional dangers of immediate fixed annuities.

First, unlike bank CDs and savings accounts, annuities are not guaranteed by the government, only by the insurance company that issues them. Putting your money with an insurance company does not avoid all risk. The insurance company may be able to guarantee an income stream on paper, but it can’t guarantee it will be around to pay it. In other words, all investing involves some element of risk.

Annuities have other risks as well.

Remember, an immediate annuity is irrevocable. That means that if a month after annuitizing your deposit(s) you are diagnosed with a terminal illness you cannot undo the annuity and use the money for medical expenses instead.

Always avoid irrevocable decisions. Life presents many challenges. You need freedom and flexibility to face whatever financial problems that may come your way.

But the biggest risk is inflation. Immediate fixed annuities have no future increase to offset inflation. Therefore after fourteen years of zero returns, the fixed monthly payments have dropped considerably in their purchasing power. Assuming 5% inflation, after fourteen years, the original $35,000 per year can only buy $17,975 in today’s dollars. And by the time the wife is widowed and her payments are reduced, she has to live off $10,179 in today’s dollars, and at the end of her life the payments are only worth $8,973 in today’s dollars.

Inflation averaging 5% or more is a real possibility over the next twenty years.

Because you can’t change your mind, and you can’t spend your money ahead of time, the best use of an immediate fixed annuity is to protect you from yourself. Call me wild and crazy, but this is not the risk I am worried about. The best investment plan is a well-managed, diversified portfolio. NAPFA (www.napfa.org) is a good place to look for a fee-only advice from a financial planner near you.

Photo by Mark Smith on Unsplash

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.