White Coat Face Off: Death with Benefits

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What a useful exercise this is.

By continuing this 14 part series of posts in which I attempt to refute the Whitecoat Investor’s well reasoned arguments against early retirement, I’m able to piggyback off of his encyclopedic understanding of all things financial and introduce important concepts to my readers.

For prior articles in this series please see these:

Is too much savings possible?
Social security implications of early retirement?
The burden of self financed health insurance?

Today’s article deals with single premium immediate annuities (SPIAs.)

I haven’t written much about annuities to date. And there are really two reasons for this.

1. I’m still in the midst of my accumulation phase, so locking in retirement income is not a priority for me at this point.

And

2. Most annuities suck.

Why do I say that?

In general Insurance should be used to hedge against devastating and unpredictable events (like untimely death, disability, fire…), and not to invest in one’s future.

Investment is investment and insurance is insurance, and in general you just shouldn’t mix them. When you do, you almost always end up with an investment product with high fees. Never a good idea.

But Single Premium Immediate Annuities are somewhat of an exception.

The way a SPIA works is that you give over a lump sum to an insurance company.

In exchange they agree to pay you a percentage of that lump sum on a monthly basis for the remainder of your life.

The longer you live the better you do financially. (And the converse is also true.)

The benefit to you is that you get a more generous annual rate of return than you would if you invested your lump sum in a similarly safe fixed income investment in the market.

This allows you to invest the rest of your money more aggressively, and withdraw a larger percentage of your nest egg going forward, because you’ve placed a floor on your retirement income level.

It is longevity insurance. You’re essentially buying your own life long pension.

But wait, you protest, how could the insurance company profitably give you a better payout than the fair market rate of return?

And the answer lies in the “death benefit.”

In any population of people, some will die prematurely, and when this happens the insurance company pockets all of the money that the deceased originally used to secure the single premium immediate annuity.

And this bonus is passed on to the other annuity owners in the pool (minus some cut for the insurance company.)

So if you die early your heirs lose out on your principal invested. In exchange for this, you have insured against the possibility of ever running out of income.

So with that in mind, let’s look at the Whitecoat Investor’s argument against early retirement vis-à-vis’s SPIAs.

Immediate annuities shouldn’t be bought in your 50s.

An immediate annuity is a way to turn a lump sum of money into a guaranteed pension, essentially longevity insurance to ensure you don’t run out of money in retirement.  Most experts recommend you buy it around age 70.  Annuitizing a portion of your stash is a wise choice for most as it allows a much higher safe withdrawal rate.  Even in our current low interest rate environment, an inflation-adjusted annuity pays 5.1% for a healthy 70 year old female.  It pays 6.8% without the inflation adjustment.  It only pays 3.7% at age 50, less than the classic 4% withdrawal rate.

This is an interesting argument to challenge.

To begin let’s imagine The 50-year-old retiree used in the Whitecoat Investor’s example.

Let’s say he retires with $2 million invested. His house is paid off. But he wants to ensure against running out of money. So he decides to invest $1 million of his $2 million in a SPIA.

As a 50-year-old he will only get $37,000 a year guaranteed from his $1 million. If only he were 70 then he could get $51,000 a year guaranteed.

And I’ll be the first to admit, $51,000 a year of guaranteed income is  preferable to $37,000 a year.

But why is he getting less money as a return on his investment?

He is getting less, of course, because he is expected to live for a longer period of time. (So if both retirees end living to the same ripe old age they will likely do about as well as each other.)

But there’s another question that we must ask. Why is the 50-year-old ready to retire at age 50 whereas the 70-year-old isn’t ready to retire until reaching age 70?

You can see where I’m going with this, right?

The early retiree is ready to retire because he has saved a much greater percentage of his money over a shorter period of time than his seventy-year-old counterpart.

He has spent less. He has saved more. He has invested more.

Which means of course that he needs much less income than the 70-year-old going forward.

The 50-year-old internist has already broken the societal norms dictating that he should spend a good percentage (or more) of his income.

He has trained his frugality muscles and gotten into financial shape.

He has focused on the purchases that really made him happier and has gone without the purchases that did not.

Put another way, to get the point where he could realistically retire at age 50, he has had to waste much less of his money than the 70-year-old retiree already has.

So while his guaranteed retirement income is only 72.5% of the 70-year-old’s, he has  already made do living on at least 50% less spending each year, just to get to this point.

His needs are less. And his income is greater relative to his need.  He is richer!

Now one could argue that the early retiree’s life has been less rich because of that which he has already forgone in terms of spending.

But I believe not. Which is why I am convinced that early financial independence is a great bargain and one worth pursuing vigorously.

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