Issue link: https://resources.envestnet.com/i/1527488
Annuities as an Asset Class for Fee-Based Advisors l 20 © Envestnet 2022 Payout Rates and Rates of Return for Income Annuities The pricing of an income annuity is typically described using either the monthly income amount it generates, or as the annual payout rate of the income received as a percentage of the premium amount. For instance, an income annuity might offer $481.67 per month for a $100,000 premium. For twelve months, that sums to $5,780, which is 5.78 percent of the initial premium amount. The annuity payout rate is 5.78 percent. After aligning with assumptions about how spending may grow with inflation, this payout rate is directly comparable to a sustainable withdrawal rate from initial retirement date assets for an investment portfolio. Both rates incorporate the idea that principal is spent in addition to any investment returns. It is important to recognize that the payout rate is not a return on the annuity, which may create some confusion. It is wrong to compare the payout rate to an interest rate that involves the subsequent return of principal. For instance, if you can earn 1 percent by holding a CD and 5.78 percent from an income annuity, the income annuity is not almost six times more powerful than the CD. The problem is that the 1 percent number for the CD only represents its interest payments. The principal value is returned at maturity. Meanwhile, a 5.78 percent payout from an annuity includes interest and principal payments (as well as mortality credits—the true source of additional returns beyond that provided by a fixed-income alternative). Principal is being spent as well, and so the comparison to the CD rate is neither fair nor meaningful. The annuity does have a return, but it is less straightforward to calculate. To know the annuity return, it is necessary to know how long the annuitant will live and how many annuity payments will be generated. Or, at least, returns can only be calculated by assuming how long income payments will be received. A longer life means more payments from the annuity, which helps to increase the return it provides over time. And if the underlying investments in the general account provide a higher return, that feeds into a higher annuity payout rate, which helps to boost the annuity's return more quickly as well. For life-only annuities, returns start out negative, as cumulative payments fall short of the premium paid. The return crosses from negative to positive when the total payments received exceed the premium paid. With enough time, the return can eventually exceed the payout rate. A competitive income annuity will provide a return matching bonds at around the owner's life expectancy. Eventually those continuing cash flows will imply returns that are competitive with stocks. An income annuity is designed to provide a higher return to people who live longer and therefore need higher returns to fund their retirements. Though tragic to consider, those who do not live as long do not end up needing strong returns to fund their retirement. This is how annuities can better match to the funding needs of a retirement plan. To know the annuity return, it is necessary to know how long the annuitant will live and how many annuity payments will be generated. Or, at least, returns can only be calculated by assuming how long income payments will be received.