Insurance Annuity Valuation Question

A reader, whom I’ll call Lady J, recently asked me if I could value her future insurance annuity scenarios vs. her current cash-out value. She wanted an annuity valuation done in the same manner as the Pension Lump Sum Case Study I wrote for the Pension Series. The question intrigued me. My initial reaction was, yes, I could. Since a Defined Benefit Pension (DBP) is just another phrase for an annuity; I didn’t think it would prove too hard if she could provide the appropriate details. I told Lady J as much, and she promptly supplied me with details I needed.

Surprisingly, the annuity valuation proved both easier and harder than I initially thought. Easier in the sense that based on the numbers provided by Lady J, my Master Pension Value Calculator spit out an answer to her question in no time. Harder in the sense that once I reviewed the terms of her annuity policy, and the facts surrounding her initial investment, it forced me to ponder numerous “what if’s”. Thus, consider this article in two parts. First, I walk through the facts surrounding Lady J’s situation and the process of annuity valuation. Second, I address a few different issues, both good and bad, I noticed with this annuity.

The Situation

When Lady J first reached out she told me that she “… was talked into putting $50K into an annuity after my husband died in 2009.“. It saddened me to read this because based on Lady J’s age (61) I could only surmise her husband’s departure was premature. Based on the language she used (talked into an annuity) it also sounded like an insurance salesperson pushed her into this annuity during her time of mourning. Unfortunate, but not uncommon.

Turns out that Lady J bought herself the Prudential Premier Retirement Variable Annuity B Series with an Optional Living Benefit known as Highest Daily Lifetime 6 Plus. I’ve attached both the (2017) prospectus and a fact card for this product below. However, all you really need to know about Lady J’s annuity account follow:

• Unadjusted Account Value (current cash-out value): $66,889.58
  • Contingent deferred sales charge period is over; no surrender fees
  • Transferable upon death if annuity hasn’t started
• Current Protected Withdrawal Value (PWV): $87,931.29
• Percentage of PWV eligible for annual withdrawal when annuity starts: 5%
  • Also known as the “Roll-up Rate”
• Optional living or death benefits: Highest Daily Lifetime 6 Plus
  • Guaranteed PWV of at least $100,000 in 2020
    • With an Enhanced Guarantee of 200% of PWV for annuity payments
  • Guaranteed PWV of $200,000 in 2030
    • With an Enhanced Guarantee of 400% of PWV for annuity payments
• 1st Annuity Option: Start lifetime withdrawals at 5% of current PWV ($87,931.29)
• 2nd Annuity Option: Start lifetime withdrawals in 2020 for 5% of at least $100K annually ($5K p/y)
• 3rd Annuity Option: Start lifetime withdrawals in 2030 for 5% of at least $200K annually ($10K p/y)

Running the Numbers

Just like the lump sum scenario in Part 11 of the Pension Series, Lady J wanted to know what the numbers showed in each scenario. I counted four scenarios: the lump sum option plus the three annuity options. Also like Part 11 of the Pension Series, I made a few planning assumptions in order for the calculations to work.

The first assumption was Lady J’s life expectancy. I used the U.S. Social Security Administration’s (SSA) actuarial tables for all my calculations, which projects the average 61-year-old female lives to 86 year old. As for inflation, I used my standard 2% annual projection. For market returns, I used the average return on the Wilshire 5000 from 1970 to this 2018, which is 6.6% after inflation (or 8.6% with my inflation rate added) with dividends reinvested. Finally, I assumed a 100% chance the annuity would payout given the fact it’s held by Prudential.

Once again I used my Total Dollar Value (TDV) method given the simplicity of the scenario. However, since I ran the projections in the Master Value Pension Calculator, four other answers from the four other embedded pension valuation methods were also available for comparison’s sake. I listed out the results of the analysis below with screenshots from the Grumpus Maximus tab in the Master Pension Value Calculator after each option.

Annuity Option 1:

• TDV of annuity: $66,987
• Annual lifetime withdrawals at 5% of current PWV ($87,931.29) = $4396 p/y
• Adjusted Lost Dollar Value (ADLV) between TDV and Lump sum: $97.86
• Invested lump sum spend to zero scenario using $4396 p/y = 44.57 years

Annuity Option 2:

• TDV of annuity: $72,927
• Annual lifetime withdrawals in 2020 at 5% of at least $100K = $5000 p/y
• Adjusted Lost Dollar Value (ADLV) between TDV and Lump sum: $6038
• Invested lump sum spend to zero scenario using $5K p/y = 44.34 years

Annuity Option 3:

• TDV of annuity: $100,494
• Annual lifetime withdrawals in 2030 at 5% of at least $200K = $10000 p/y
• Adjusted Lost Dollar Value (ADLV) between TDV and Lump sum: $33,604
• Invested lump sum spend to zero scenario using $10K p/y = 34.78 years

Analysis

My TDV analysis shows the $10K annuity that starts in 2030 provides Lady J the largest value for her money. Furthermore, most of the other embedded pension value calculation methods in the Master Pension Value Calculator show the same … to a much larger degree than my method. Of course, that assumes Lady J lives until 86 years old, or older — which we all hope she does.

I think it’s also important to note that cashing out the annuity at this point does nothing for Lady J other than transferring the risk of running out of money back to her. I say that because Lady J has already eaten most of the costs attached to this annuity (more below). Unless she is willing to reach for a higher rate of return than the 8.6% my analysis uses, and therefore assume more risk with an invested cashed-out lump sum, then she is probably better off sticking with the annuity.

My analysis above assumes that concern for the safety of this money compelled Lady J to take out this annuity in the first place. If that’s a false assumption, then the current cash out value is competitive with all the annuity payment scenarios … if Lady J can stomach the risk of investing aggressively (100% equities) and is willing to spend down to zero. That’s a couple of big “ifs” that I don’t know the answer to since she didn’t supply me that information.

It also ignores the chance of sequence of returns risk as this post-Great Recession Bull Market enters its 10th year. As Big ERN McCracken pointed out in a recent article at Early Retirement Now (ERN), long periods of above-average growth in the U.S. stock market correlate highly to subsequent long periods of below average growth in U.S. markets. Avoiding that sort of risk and volatility is the reason annuities like Lady J’s exist.

Finally, there’s a question regarding the death benefits attached to this policy. In an email to me, Lady J specifically stated, “At my death, it does pass on to my 3 daughters. If there is anything left.“. Since she mentioned it several times, I presume she values this aspect of her policy heavily. Yet, as I re-read through the prospectus while making some calculations, I came across the following passage:

“The Annuity provides a death benefit prior to Annuitization (the “Minimum Death Benefit”) and, for applications signed on and after May 1, 2017, an
optional death benefit, Legacy Protection Plus, is available.”

I realize the prospectus I found online is from 2017, and Lady J’s 2010 policy may include a different type of death benefit, but Lady J never specifically mentioned anything like Legacy Protection Plus in her emails. My main concern is that Lady J may erroneously believe her policy’s value can be passed onto her daughters after annuitization begins.

The bottom line for the annuity valuation is that my above analysis assumes Lady J is correct, and that her annuity’s remaining value can be passed on to her beneficiaries after annuitization begins. Thus, according to my calculations, the $10K per annum scenario starting in 2030 remains the most valuable. If the beneficiary assumption is false, it upsets a lot of my analysis and makes a cash out a lot more attractive.

Alternate Analysis

With 20/20 hindsight, what else can I make of Lady J’s annuity purchase? Quite a bit actually. Let’s start with performance metrics for her money within the annuity. Based on the current cash out value ($66,889) her annual rate of return from 8/19/2010 to 1/1/2018 was only 3.7%. Compare that to a 13.3% (nominal) annual rate of return for the Wilshire 5000 over the same period. A 13.3% annual rate of return would have grown her $50K to $135,829. Put in those terms, the decision to buy the annuity appears regrettable.

However, that’s something of an apples to oranges comparison since at the end of the day an annuity is an insurance purchase. The “insurance” Lady J purchased, in this case, was a guaranteed rate of return for her $50K. When one does the math, it turns out she purchased a 7% (nominal) guaranteed annual rate of return. I based that calculation on the guarantee of at least $100K in PWV by 2020 and at least $200K by 2030. This (nominal) 7% annual rate of return also tracks closely with the 7.3% rate of return earned within the current PWV of Lady J’s account ($87,931).

For comparison’s sake, Treasury Inflation Protected Securities (TIPS) provide an equivalent guarantee of safety available to market investors. If we use the iShares TIPS Bond ETF as a proxy over the same investment period in order to compare performance, we find it only returned 2.76% annually. Thus, Lady J’s money would’ve only grown to $62,285 if she’d invested in TIPS.

While 7.3% annual rate of return isn’t 13.3%, it’s not 3.7% or 2.76% either. Let’s also remember Lady J bought this policy within 15 months of the market bottom caused by the Financial Crisis. While we now know the U.S. stock markets had already started their inexorable climb to today’s current highs; no one at that time could’ve predicted such a turn of events.

Of course, the safety that Lady J bought comes at a cost. That “cost”, although not necessarily apparent to a lump sum investor like Lady J, comes in the form of expense fees charged annually. Those fees come out of the “dividends” her investments (within the annuity) earn over the year. Which helps to explain the lower annual rate of return for her money. Lady J sent me a table from her policy that projects her total expenses including optional benefits across 10 years:

• 1 yr. $1315
• 3yr. $3718
• 5yr. $5847
• 10yr. $10,158

Even I can figure out that $10K of $100K (which was the guarantee) equals 10%. Whether or not the 10% is worth it to someone depends on what they value. If they value the safety of their money over everything else, then maybe it is. In my opinion, 10% is a hefty cost for a vehicle that doesn’t match market returns. Possibly the best thing I could say is that it might be worth paying 10% over ten years to protect accumulated wealth, but it’s a sub-optimal way to grow wealth for a person in the wealth accumulation phase.

Taking everything above into consideration still leaves two outliers. The first is inflation. While Lady J’s policy guarantees a certain rate of growth, as far as I can tell there’s no hedge against inflation after annuitization. Once she takes her $5K or $10K annuitization, she’s locked into that dollar amount for life. Which means the value of Lady J’s annuity payments will decrease in real terms year-after-year. Projected forward at a 2% inflation rate, $10K’s purchasing power in 2030 equals $7,884 in today’s dollars. It will shrink further to $6,095 by the time Lady J hits 86 (2043).

Finally, the other outlier is the beneficiary issue. Just how transferable is this account upon Lady J’s death? Is the transferability contingent upon whether or not annuitization started? Or does Lady J have a different clause in her 2010 version of this annuity? In my humble opinion, the answer to these questions changes the calculus as to how good of an investment this annuity turns out to be. The ability to transfer it on, even after annuitization, make it a far more valuable insurance product than it otherwise might be.

Conclusion

For once in my life, I was right about the ease of a mathematical problem. It turns out that annuity valuation is possible using the tools I developed for pension valuation. Or at least it proved possible in the case of Lady J’s insurance annuity. Given the variety of annuities out there, my tools may not always work. In this specific case though, my TDV method showed the 2030 $10K per year annuity offers Lady J the most value if she lives until 86 years old. The other pension valuation methods in my Master Pension Value Calculator corroborate that assessment.

In true Grumpus Maximus form though, I didn’t leave it there. I felt compelled to dive deeper into the pluses and minuses of this specific annuity. Lady J bought herself an incredibly flexible annuity, that provides both a 7% annual rate of return guarantee and some ability to pass it on to her daughters. The safety and flexibility in her annuity came with a cost though, apparently in the form of $10K in projected fees during a 10 year period. There’s also the opportunity cost of what her money could have done had it not been invested in the annuity.

However, most of those costs are what economists term sunk costs at this point. In other words, they are irrecoverable. The math in my TDV method shows that cashing out the annuity and investing it at this point could prove potentially competitive. In other words, an invested cashed-out lump sum could sustain equivalent withdrawals as to what the annuity provides in all scenarios. However, doing so assumes a lot of risk — specifically sequence of returns risk. It also assumes Lady J would be willing to spend the invested cashed-out lump sum down to zero. The only reason I would personally entertain a “cash-out and invest” scenario is if the underlying assumptions about the transferability of the annuity are incorrect. Otherwise, since Lady J already paid most of the costs of this annuity, she might as well reap the reward.

Finally, as I stated in Part 1 of the Golden Albatross vs. the Insurance Industry Series, much like Darrow Kirkpatrick I’m a believer that there is a time and a place for certain insurance products like annuities in the life of a retiree. This case study has only served to reinforce that belief. It highlights the same pluses and minuses that Darrow discusses on his blog. In this specific case, the best I can say about the annuity Lady J bought is it appears to be a great tool for protecting wealth once someone has already accumulated it. However, based on the above-mentioned fees and opportunity costs, I would not recommend it as a method for building wealth. I think Lady J had already come to the same conclusion prior to contacting me. Now she has the analysis to justify that belief.