With Interest Rates at Historic Lows, Annuities are Actually a Bargain

With Interest Rates at Historic Lows, Annuities are Actually a Bargain

Interest rates are historically low. While

low rates can be bad news for investors, low interest rates actually impact retirement income strategies differently and make certain products—in particular annuities—more attractive, at least relatively speaking. This may sound counterintuitive, but here’s how it works.

There are two key components that drive annuity payouts:

  1. The age you are when you begin taking guaranteed income from your annuity; and
  2. the prevailing interest rates.

Since interest rates are low today, the payout you would get from buying an annuity is lower than if interest rates were higher. However, because of another important concept called mortality risk pooling (a term that accounts for the fact that some people who purchase an annuity will die relatively young, while others will live a long time) the payout is collectively higher than it would be for a person with a self-funded retirement plan—that is, someone who relies only on their own investment portfolio. Mortality risk pooling means that the relative benefits of annuities are even higher when interest rates are lower compared to other investment products.

Take, for example, a couple consisting of a 65-year old male and female who want to use a bond portfolio to generate retirement income. They want to be certain they’ll have enough income should either of them live a long time—which is becoming increasingly likely since retirement is assumed to last until age 100 (or 35) years. Based on the assumption that bonds are yielding rates as low as 1%, they would need $29.41 for each dollar of income—ignoring inflation and taxes while assuming that they will spend down their principal over time. That means, in order to produce $10,000 in annual income, an investment of $294,100 is required.

Annuities are one of the few financial products that are actually more attractive today.

In this same scenario, an immediate annuity generates more income for every dollar invested. To produce $10,000 in annual income, the couple would only need $255,279 – which is 13% less compared to a portfolio of bonds (a.k.a., the “self-funded investor”).

What’s going on here? The self-funded investor and the annuity buyer are both buying bonds at the same lower rates, but only the annuity buyer is realizing the added benefit of mortality risk pooling provided by the insurance company. In other words, because of mortality risk pooling, the insurer is able to offer higher income in an annuity than an individual would be able to obtain on their own by purchasing a bond. To that end, today’s historically low interest rates mean that annuities are a bargain, at least relatively speaking.

According to a recent survey conducted by the Alliance for Lifetime Income, 56% of those Americans who are not yet retired are rethinking their retirement plans—a trend that is no doubt the partial result of the current near-zero interest rate environment. Annuities are one of the few financial products that are actually more attractive today, and therefore are worth considering as part of a retirement income strategy.