Investing your money generates more money by earning interest on what you put away. When you take the time to learn investing basics, there is less risk involved. You learn to choose stocks that will generate more money for you in the future.
Bottom line: the best way to make money without working for the rest of your life is to invest.
However, people often see annuities, a sum of money invested to produce a monthly income for a fixed period (or for life), as more attractive than investing in stocks. Especially when interest rates move higher.
In reality, annuities are not so simple.
The ‘Dumb and Dumber’ of Market Hypotheses
I am often asked, “Why do you have to pick individual stocks? Wouldn’t it be a lot easier to simply set up a savings program? And then invest monthly in a group of stock indexes and bond funds using dollar-cost-average tactics and diversification to build a retirement nest egg?”
Anyone with a decent job, a bit of foresight and fiscal discipline can do that.
That strategy is, in fact, what the entire rest of the financial services world has been recommending ever since a group of academics did a thought experiment about risk.
They ended up with the Dumb and Dumber of market hypotheses – the Efficient Market Theory and its moron buddy, Modern Portfolio Theory.
As we’ve discussed many times, Dumb and Dumber managed to get Nobel Prizes for telling the world that the stock market is rational, the price is value, the risk is volatility and nobody beats the market.
They got the Prize in spite of the obvious – that the market is full of the emotions of fear and greed and, as a result, the price is sometimes vastly different than value. The risk isn’t short term volatility – it is not understanding what you’re buying, and lots of people slaughter the market.
Life Gets in the Way of Fiscal Discipline
But besides all that … why not just do what they tell you to do? Everybody else is.
It is not that Modern Portfolio Theory can’t produce some positive results for lots of people, it can. If you follow the prescription long-term you’ll almost certainly have a lot more money than if you just put your money in a savings account.
Someone who maxed out an IRA for 40 years at $5000 per year pre-tax and diversified across bond and stock ETFs would probably average 7% compounded per year.
They will have about $1 million at retirement, a substantial increase over the $200,000 contributed and vastly more money than the average new retiree has in their portfolio today.
Even ‘investing’ like this is not easy. Life gets in the way of fiscal discipline.
It is hard to tell your wife the kids will have to grow up in the more dangerous, not-so-kid-friendly neighborhood because you don’t want to ante up for a more expensive house near the better schools.
It isn’t easy to tell your kids to find their own way to pay for college when you’re sitting on top of a few hundred grand.
Or, God forbid, your savings and investing plans get disrupted by ill health, job layoff, robbery, war, flood, a bad house foundation, divorce or any of the other nearly omnipresent disasters that can befall humans.
An Annuity is an Insurance Policy That You Buy
But, let’s assume you dodge the odds and arrive at retirement with a million bucks. You’re rich, right?
So now, rather than continuing to bet that investments will continue to go your way, you decide to take advantage of the rollover provision of an IRA. You decide to roll that nest egg over, tax-free, into something you can count on – a retirement plan.
Just like the old generation had or like your Congressman, the mailman, your 3rd-grade teacher, the county clerk and nearly every other public servant has; you have a guaranteed amount per month that you can count on.
You want to live in your retirement as if there is certainty in the world. You want steady monthly income that isn’t dependent on the stock market or the bond market. You decide to roll the IRA over into an annuity.
An annuity is an insurance policy that you buy.
The policy guarantees you a certain amount of money every month for as long as you live. Annuities are sold as if they are the answer to a worry-free retirement and they can be purchased with money from your IRA without triggering any tax bill.
You only pay taxes on the monthly income as it comes in. Awesome.
Here’s the Catch
So, you go shopping for one. You find that annuity that you can buy for $1 million for you and your spouse’s lifetime from an A+ company right now pays out a guaranteed $4800 per month for life.
That’s fully taxable income to you because you’ve never paid taxes on any of the money in the annuity (it all came from your pre-tax IRA money) so you’ll be paying taxes on the $4800. However, don’t forget to add in another $2500 a month from social security between the two of you.
With social security, your taxable income will be around $7200 per month. Figure your take home is, after tax, about $5000 per month.
Not bad, not bad at all. Probably a bit of a drop from what you’re used to living on but you can take in the belt a notch and you’ll be good to go.
However, even though you own a guaranteed income, it is a fixed income. There is no inflation rider. No CPI adjustment. You’ll be living a $60,000 a year lifestyle today.
But here’s the catch…
That lifestyle will be getting squeezed by inflation a little bit each year.
When Annuities Won’t Cut It
Every year, if inflation stays at historical levels, you’ll lose about 3% of the buying power of that monthly annuity income. In ten years, by the time you are 75, you’ll be trying to get by on $3600 a month in today’s buying power.
For two people, that isn’t a lot of money. At 80 you and your spouse are down to $3000 per month in current buying power and serious financial trouble is looming.
At 85, just about the time the kids are helping you find an assisted living home you discover that assisted living costs are about $3600 per month per person in today’s dollars and you’re buying power is down to a $2500 per month total.
If both of you are still alive at this point, you’ll have to forget about assisted living. You can’t afford it. The good news is you won’t have to pay for trips to see the kids…your ‘assisted living’ solution will be the basement of your kid’s house.
It gets worse…
Since you put every cent you have into the annuity, there is no cushion for sudden financial shocks. If there is a big medical expense, you can borrow some money out of the annuity but how can you repay it?
The right answer is to hold a year of living expenses in cash out of the annuity – in this case, about $60,000. You might have to pay tax on that money if IRS rules force the money out of the IRA.
If that happens, you’ll need to reduce your annuity by something like $85,000 and your monthly income for life will be reduced by about 8.5%.
What is the Answer?
If annuities don’t cut it, what’s the answer?
You could plan on dying young. But for most people, according to most financial advisors, the only solution is to continue to invest in stock and bond ETFs, typically in a 60%-40% ratio.
Assuming you do so, you are likely to be able to make about 1% increase of the portfolio from bonds and 4% from stocks per year on average. This is likely to solve the annuity problem by keeping your investments ahead of inflation.
But now you have a new problem – that the average return, while steady in bonds, is wildly volatile in stocks with periodic drops of 50% and common drops of 20%.
If one of the big drops happens early in your retirement and lasts a few years, you will deplete your capital invested in stocks because you’ll be drawing 60% of your monthly income from principle rather than investment gains.
All in all, there are “pros” and “cons” to annuities. I just happen to see more of the “cons.”
However, if you take the time to learn how to invest and best investment strategies, the risk-factor decreases and you earn money faster. You will be well on your way to a financially stable and successful life. Learn to make your investment research faster and simpler with my easy-to-use investment calculator. Download it for FREE and make sure your numbers meet Rule #1 requirements!
Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.