Where to Find Annuity Payment Information

Bob continues, “I found the ‘Monthly payment’ amount at immediateannuities.com by putting in your and Jim’s ages, saying that you wanted to start payments immediately, and selecting $100,000 for the amount to be invested. The ‘Estimated taxable amount’ is the result that immediateannuities.com calculated for payments starting ‘immediately’ (a month after I entered the data), given your ages and an investment of $100,000. Clear so far?”

Jane says, “I know you explained this before, but why did you specify the investment as $100,000 rather than the amount that my mother is thinking of giving me?”

Bob replies, “Well, of course we could have directly put in the amount your mother is thinking of giving you and checked to see how much that would improve your spending. But the idea of the optimizer is to try different investment amounts to see which would improve your spending the most (assuming any of them would cause an improvement in the first place). That’s why we always put in the payment amount that you could get for a $100,000 investment. Once the program has that number, it tries a number of different amounts to invest and sees which one provides the most sustainable spending. It’s like the way it searches for how much insurance you need to optimize sustainable spending by trying a number of possible terms and face amounts.”

Why Knowing the Exact Starting Dates of an Annuity is Important

Jane says, “Ok, I do remember that. But why does it matter exactly what date the payments start? I don’t remember that being an issue with the life insurance policies the program recommended.”

Bob responds, “Annuity rates fluctuate a lot more than life insurance rates. Most life insurers change their premiums every year or two, whereas annuity rates can change every day. The reason is that annuity rates are very dependent on interest rates, because when the insurance company writes an annuity policy, they are committing to paying you a set amount every month for the rest of your life, based on the amount that you invested with them. Now of course some of that calculation is based on their estimate of how long you will live, just as life insurance rates are, but in the case of life insurance they are promising to make only one payment at a future date, assuming you are still insured when you die. If you outlive the term of insurance, they don’t have to pay anything, so in that case, interest rates are almost irrelevant. But let’s assume that they do have to pay your survivor when you die. In that case, they have been collecting premiums and investing them, so interest rates do matter somewhat. But at least with the current very low rates, they don’t earn very much on those invested premiums, so a small change in interest rates doesn’t affect them very much.”

Bob continues, “On the other hand, with an annuity policy, they know that they will have to pay you for the rest of your life, based on the amount you invested with them. Let’s suppose that they expect to make 5% every year on an investment of $100,000. In that case, vastly oversimplifying by ignoring the fact that you will die one day as well as the insurance company’s profit margin, they can pay you $5000 a year. But if interest rates go down to 4%, they can pay you only $4000 a year. So, a 1% reduction in interest rates reduces the amount they can pay by 20%. And remember, as soon as they commit to paying you a set annuity payment, they have to keep doing that no matter what happens to interest rates after that point, so they have to be very careful what they promise. Since interest rates fluctuate every day, so do annuity rates.”

“For this reason, an annuity quote is good for only a few days; if you wait too long, we’ll have to get another quote. Does that make more sense now?”

Jane answers, “Yep. Ok, what’s next?”

Deferred Annuities Can Also Improve Sustainable Retirement Spending

Bob replies, “Although the annuity quotes I got for you before were for an ‘immediate’ annuity that, as the name indicates, starts paying (almost) immediately, the program doesn’t require payments to start right away. It can also handle ‘deferred’ annuities that don’t start paying for quite a while, so long as the monthly payment is known in advance. Let’s look at an example of such a deferred annuity right now to see if it might be better than the immediate annuity that we looked at yesterday.”

Bob goes to the immediateannuities.com web site and puts in Jane’s and Jim’s birth dates, selects $100,000 as the amount to be invested, and sets the starting income date to ’10 years’, which results in a quote of $736/month, of which $460 a month is estimated to be taxable, with a starting date of 5/5/2027. Then he hits the “Optimize Annuities” button, resulting in Figure 9.3.

Bob continues, “Let's compare that ‘Yearly Spending’ number of $64,384 to the immediate annuity result that we got earlier.” He reloads that previous result, which is shown in Figure 9.4.

“Well, it looks like the immediate annuity is producing a better 'Yearly Spending' value, at $64,806, so there’s no point in deferring the income. Does either of you have any questions on this?”

What Happens after the Death of One or Both Annuitants?

June says, “Yes, I do. What happens if Jane or Jim dies? Do the payments continue?”

Bob replies, “Yes, all of the annuities that the program suggests are the type called ‘Joint & 100%’, meaning that the payments continue unchanged until the death of the second spouse.”

Jane adds, “Ok, but what happens when both of us die? Do our heirs get anything?”

Bob answers, “That depends on the rules of the annuity that you purchase. Some annuities will pay the remainder of the original investment to the estate of the second spouse to die. For an annuity like that, we check the ‘Return of Premium’ checkbox, on the ‘Suggested Annuities’ tab. If that is checked, then the remainder of the premium will go into your estate.”

“Actually, the quotes from immediateannuities.com include annuities with and without the return of premium feature. What do you think happens to the payment if you want to add that feature?”

Jane says, “I imagine the payment would go down because in that case they would need to pay out money if we both died before we got the whole premium back, which they wouldn’t have to do otherwise.”

Bob replies, “Absolutely correct. Want to guess how much it would go down?”

Jane answers, “Hmm, maybe 10%?”

Bob says, “Well, the monthly payment per $100K is only about 3% lower, at $418 per hundred thousand, but let’s take a look and see whether it affects the suggested purchase amount.” He enters the new monthly payment of $418 and the new estimated taxable amount of $151, checks the “Return of premium” checkbox, then clicks the “Optimize Annuities” button. The resulting screen looks like Figure 9.5.

Bob continues, “Hmm, interesting. Apparently, the recommended annuity purchase amount is still $340,000, so the payment went down about 3%, just as the payment per $100K did. The yearly sustainable spending accordingly went down about $300/year. So, the return of premium feature wouldn’t cost much in your case. What does that mean?”

Jane says, “It must mean that they expect that we will probably live long enough to get the whole premium back without the refund. Right?”

Bob replies, “Right. If both of you were older, then that feature would be more expensive, because then they would have a bigger chance of having to pay your heirs some money after you both died. This is also true of single-life annuities with the premium refund feature, because it is more likely that one person will die in a relatively short period time than that two people will both die during that time.”

"So would you like to keep the annuity with return of premium, considering that it doesn't cost you very much? Obviously it would improve your legacy if both of you did happen to die early."

Jane answers, “Yes, since it doesn't cost that much I think we should pick that option.”

Bob nods, and is going to continue, but then June chips in with, “I have another question.”

Adjusting Annuity Payments to CPI

“What about that other option, ‘Adjusted to CPI’? What does that do?”

Bob replies, “CPI is short for ‘Consumer Price Index’. You can also buy annuities with inflation adjustments that increase the payments according to the increase in the CPI. Of course, those annuities are more expensive than those that just pay the same amount every month so long as you (or your joint annuitant if it is a joint annuity) are alive. For example, the quotes I got for Jane and Jim include that option too. Here’s what the results look like for that option.” (See Figure 9.6)

Bob continues, “Notice that in this case the program is not recommending the purchase of an inflation-adjusted annuity because it would reduce ‘Yearly Spending’ assuming that our inflation projection is accurate. So if we want to investigate the possibility of adding the CPI adjusted annuity, we will have to adjust our inflation expectations to a point where such an annuity would improve spending. This is again a way to reduce risks, in this case the risk of higher than anticipated inflation, at the cost of a slightly lower sustainable spending if our assumptions are correct. Do you want to try that?”

June answers, “No, I don't think that will be necessary. I'm happy with the existing assumptions.”

Bob continues, “Also notice that the ‘estimated taxable amount’ is 0. That number comes from the annuity quotation from immediateannuities.com. Your tax person should be able to calculate the actual taxable amount. Any other questions on the topic CPI adjustments?”31

June shakes her head.

Bob continues, “Okay, let’s go back to the previous annuity calculation with the return of premium feature, and go over the rest of the features that we haven’t discussed yet, starting with the left-hand side of the main screen.” (See Figure 9.7)

Bob continues, “The first field on that left-hand side is ‘Year simulation starts’. That defaults to the current year, but we can change that if we want to start in a different year. Of course most of the time we will want to begin the calculations this year, but there are a couple of reasons that we wouldn’t want to do that:”

“The next field is ‘Yearly Spending’, which we’ve already discussed in detail. But to summarize, that is how much money you can spend every year from now until your conservatively estimated life expectancy, without running out of money while you are still alive. That is the current amount of spending, and is adjusted every year according to our estimate of inflation, which is why the ‘level spending’ doesn’t look level but seems to increase every year; it’s actually level in ‘real dollars’, with the exception of any ‘Expected Additional Expenses’, which are added in the years that they are expected to occur. Any questions so far?”

Why we Might Want to Compare Last Year’s Projections with this Year

Jane says, “Why would we need to compare to last year’s results?”

Bob replies, “When we get together again next year, then we will need to rerun the results because (I assume) both you and Jim have survived until next year, so that’s one less year that we have to worry about either of you dying in. And, of course, your term insurance will have one less year to go, and there will be different inflation numbers, tax brackets, and other variables. So, this should be done at least once a year, and more frequently if anything changes significantly so that the previous results wouldn’t be meaningful anymore.”

Jane asks, “What sort of changes would do that?”

Bob replies, “If there is a major change in taxes, that would require the program to be updated and we’d need to rerun it with the new information. Or if you win the lottery, get an inheritance, or anything else that affects your assets significantly. Any more questions on that?”

Worst Case Longevity Results

Both sisters shake their heads, so he continues, “Next we have the ‘Worst case longevity’ box, which shows the estimates for two very important amounts: the total income taxes that you and your spouse will pay during your remaining lifetimes (‘Total income taxes’), and the amount of money that you will leave to your heirs after both of you die (‘Legacy’), assuming that the years of death for both spouses are the ones that the program computes as causing the lowest sustainable spending.”

June asks, “I understand the total taxes, but why is the legacy such a low number in all of the cases you have shown us so far? It’s not usually 0 as it is in this case, but it’s always pretty small compared to the yearly spending.”

Bob explains, “Ideally it would always be 0 because the program is trying to figure out how the maximum amount you can spend without running out of money before the second spouse dies. Any amount left over is money you could theoretically have spent while you were alive. However, it usually can’t get it down to 0, for a couple of reasons: First, because spending even a little more in an earlier year can cause an increase in taxes which could make you run out too early, and second, because the calculations aren’t done to the dollar for reasons we’ve discussed before. Does that make sense now?”

They nod, so Bob clicks on the “Personal Data” tab, then says, “Okay, now let’s move to the right side of the screen.” (See Figure 9.8)

Median Longevity Results

“The top box, labeled ‘Median longevity’, has information corresponding to the information in the ‘Worst case longevity’ box on the left, except in this case the numbers for income taxes and legacy are based on both of you surviving to your median longevity (‘life expectancy’), which in this case is 2050 for Jane and 2042 for Jim. Since this is considerably better financially than the worst case in which you live until 2061 and Jim dies in 2032, you end up leaving a significant legacy, estimated at almost a million dollars. Any questions about this?”

The Worst Case Years of Death

Neither of the sisters has any questions, so he continues, “Next, we have the ‘Year Search Results’ box, which shows the years of death for both you and Jim that the program has determined would produce the lowest sustainable spending.” (See Figure 9.9.)

“As is normally the case, the worst death years for sustainable spending are that you live until your ‘Max Lifespan’, which is your 90th percentile life expectancy, whereas Jim dies immediately after your suggested insurance expires in 2032.” He clicks on the “Suggested Insurance” tab, then slides the year slider over to show years 2031 and 2032, resulting in a screen that looks like Figure 9.10.

“As you can see, the starting date for both your and Jim’s suggested insurance is 1/1/2017 and they have a term of 15 years, which means they would expire at the beginning of 2032. That’s why the insurance premiums near the bottom of the screen disappear in 2032. Any questions about this?”

Jane says, “Yes. Why does the insurance start in the past? We don’t have it yet, and it’s not January any more. Shouldn’t it start in the future, maybe June 15th so that we have time to get the applications in and have them approved?”

Selecting the Starting Date for Life Insurance

Bob replies, “Yes, that is a good point. I can change those dates and rerun it to see if it makes any significant difference. Let’s see.” He changes the insurance dates to June 15th and clicks the “Optimize Insurance” button. (See Figure 9.11)

Bob continues, “Hmm, interesting. It increased the term to 20 years and reduced the face amount slightly to $400,000. That increased the premium, but also increased sustainable spending by about $1500. I think what happened is that the amount of your premium was limited by its percentage of your overall cash flow, and since you now have more potential cash flow with your higher asset level, the program recommended a longer insurance term to increase sustainable spending”.

“By the way, I see that a side effect of this change is that the worst death year for Jim is now 2017; that sort of change can happen with even a small difference in the input data.”

“We can go back and check what the optimizer does before and after adding the $500,000 to your assets, if you want me to do that.”

Jane says, “No, I don't think that will be necessary at this point. We can decide on the term later, right?”

Bob replies, “Yes, if the insurance company approves you for the face amount that we applied for, they should accept any term that they will write for people your age, and of course reducing the face amount would be possible as well. But since you bring that up, I should check to see what happens if we make the starting date May 31 instead of June 15. The insurance company I am using goes by ‘age last birthday’, which means that it would consider both of you a year older if you purchase the insurance on June 15 because both of you were born on June 1. Let's see what that does.” He changes the date and clicks the “Optimize Insurance” button, resulting in a screen that looks like Figure 9.12.

Bob continues, “That saves you over $400 a year compared to waiting until June 15th to buy the policies. That’s because you are still a year younger for insurance purposes at the end of May than you will be a few days later. Since it also has almost no effect on the sustainable spending, perhaps we should try to get the policies dated before that birthday so that you can get the lower rates. Any more questions?”

Jane says, “I don’t have a question, but I have made a decision. We’ll buy the insurance and the annuity.”

Bob replies, “Great! Let’s fill out the paperwork for both of those so we can get the process started with the insurance companies. How about you, June?”

June answers, “I’ll have to think about the annuity. That’s not as urgent because we already have the insurance.”

Bob continues by saying, “Thanks both of you for all of the time you’ve spent with me. Any other questions on the whole process?”

Jane says, “Actually I do have one more question now that you mention all of the time we have spent. I assume that you will be compensated as a result of our buying the insurance and the annuities, as I doubt this is a hobby for you. Can you explain how that works?”

Bob replies, “Sure. The life insurance company pays a commission which amounts to roughly the whole first year’s premium, about $4,000 in the case of the policies for you and Jim. I don’t get all of that, since some of it must go to my ‘general agent’ who takes care of dealing with the insurance company so I can concentrate on my clients. I’ll get about 80% of that amount, or about $3,200.”

“Now for the annuity, the commission is about 3% of the premium, depending on exactly which policy you buy, and I get most of that. So that would amount to about $10,000 if you buy the $340,000 annuity. Any other questions on this?”

Jane shakes her head “no”, but June says, “Does your commission on the annuity affect how much it pays?”

Bob says, “Sure, because that money has to come from the premium that the client pays. But the amount that the annuity pays is the amount that the program shows, because the commission is already included in the quotations from immediateannuities.com. Anything else before we wrap this up?”

Jane replies, “So we aren’t going to cover the Expert Mode in any detail? I know you showed us some of those features, but I’m sure there are other things it allows you to do.”

Bob says, “I can send you some documentation on how the other features work, including a command-line interface to the program and its scripting language for batch processing. How’s that?”

Jane agrees, so Bob shuts down the program and starts going over the forms for the insurance applications with her.