Saturday, August 08, 2009

Business Week on Pensions

The usual gang of ruffians and I have been puzzling over a Business Week story by Amy Feldman on why you should buy an annuity. She offers an analysis by Brett Hammond from TIAA-CREF. Per Feldman, he says that "corporate employees with higher income might need 60% [of their pre-retirement income], along with Social Security. She says he thinks you'll need 7.7 times your final earnings to fund this package. She says he assumes a six percent interest rate and a 25-year life expectancy. She calls these "relatively conservative assumptions." (link).

Let's do the numbers. Assume a final salary of $80,000. Multiply by 7.7 and you're lookin' at a fund of $616,000. Now take 60 percent of that 80k and you're lookin' at an annual draw of $48,000.

Run a standard annuity formula. It says that the amount you need to amortize payments of $48,000 a year over 25 years is $613,601. That assumes you get paid at the end of the year; pay at the beginning of the year and you need $650,417--a tad higher, but still somewhere in the ball park.

But wait--per Feldman, Hammond also appears to assume that his six percent rate is a "real" interest rate--i.e., an "effective purchasing power rate," i.e., free of inflation. Is TIAA-CREF really offering to sell me a 25-year annuity positing a real growth rate of six percent? I don't think anybody gets that kind of return, except George Soros or Warren Buffett in a good year. Am I to assume that a big investment fund will offer that rate to a schlep like me at retail? If so--where is my wallet?

A couple more points: one, is this me only, or is this a "survivorship" benefit--me and my wife, whichever lives longer? And it is an "annuity," right? I.e., it keeps paying even if live more than 25 years? Cuz if I were my wife and I were each 65 (I wish!)--the chances that at least one of us make it to 90 would seem to be very good indeed (or not so good, if you think of what 90 might be like).

I make a lot of mistakes at this sort of computation but I don't think I'm making one here. So, what am I missing?

Afterthought: It seems to me that this couple might well be looking at a Social Security payout of another 35-40k. Add this to the 48k alleged in the BW example and you are up into the 80s--actually, a bit higher than the assumed final salary. That would look mighty nice to most prospective retirees. Is sit reallly what s/he meant to say?

Tech Note: The annuity formula is (1/r)(1-(1/(1+r)^n)), where r=0.06 and n=25. I double checked with the PVAL function. Got the same result both ways.

Update: Ah, now we are getting somewhere. Joel points me to a Vanguard* annuity calculator. I asked it to value a lifetime annuity on $616,000 for a 65-year-old single without inflation adjustment. The machine cackled and spit out $45,348.12, which is pretty much in line with the data above. I repriced it with inflation adjustmens and got $32,664.96. Then in addition I threw in a 100 percent survivor benefit and got $24,592.20. These numbers make a lot more sense.
*I checked the TIAA CREF website,didn't find a calculator. Not to say they don't have one, I just didn't find it. But I assume these protects are competitive within a gnat's eyebrow.


chrismealy said...

The investing strategy in the article is a bit too fuzzy (or my reading comprehension is too poor). Are they assuming the hypothetical investor is in 100% stocks until the buy an annuity at retirement? That's crazy talk. And you're right, 6% real return is not conservative return. That's basically what stocks return. Investing in 100% stocks is not conservative.

As for the annuity, only a few companies offer real (inflation-adjusted) annuities. The government only started selling TIPS in 1997, so before that there wasn't really a good way to offer inflation-protected annuities. I plugged the numbers from the article into Berkshire Hathaway's (non-inflation protected) annuity quote tool, and it priced an $48,000 annuity to a 65 year-old at $660,000. An inflation-adjusted annuity would cost a lot more.

Vanguard used to have a real annuity quote tool on their site, but I'm guessing they took it down because it was really being provided by AIG, and that doesn't look so hot anymore.

G F Mueden said...

This is a minimum. nocushion. OK only if nothing bad happens. Add in a disaster or two, grandkids needing help. and end of life expenses; it won't be enough. ===gm===

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