The analysis of 15% guarantee sounds satisfactory since it is above the average and the historical average in the country. Going by such a rate, it means that the investment in the annuity will earn an amount of 240000 annually which is above the $120000 required for annual maintenance. However, the couple has a high aversion to risks and unaware of the market shocks and the decline in stock prices that the country experienced in 2008. They, therefore, feel that your analysis is not adequate to address these concerns.
Supposing that the market experiences financial problems again, and the value of the annuity declines below their annual expenses, will you be in a position to address our maintenance issue? They, therefore, feel that this is the point of concern that you should address to guarantee them value for their money to sustain them even during turbulent times and meet their annual expenses.
Moreover, they strongly feel that, though your analysis is appealing, you have not taken into consideration the number of years they are willing to provide the outlined annual income. This is because, for instance, according to your analysis the investment may give them an annual income of $240000 for 10 years. This is well above the annual expenses, but it does take into consideration the inflation rate in the country. As such, the income in three years' time may only be worth the $120000 that they are currently spending. Therefore, assuming that their lifetime is up to 85 years, and they receive income for ten years, it means that they will not have income to sustain them for the remaining years.
Moreover, the analysis conducted is inadequate in the sense that it does not give the couple alternatives so that they can choose from the alternatives. The couple is just interested in annual incomes that will guarantee that they maintain their lifestyles. However, they may not have financial information about annuities and the market performance, and a mere guarantee of payments above what the market is offering is insufficient to address their concerns. As a result, it is important to address and seek out several alternatives and weigh the best that suits the couple.
It is important also to remember that; it is wise not to put one's eggs in one basket because the risks are high and therefore full investment of retirement savings into annuities alone is not prudent. Though annuities guarantee income for life regardless of market performance, by not putting all the savings into it may help someone preserve some capital for unforeseen circumstances such as emergency medical bills. As such, it is wise to consider several factors that may be attached to annuities and that are geared towards addressing some of the issues raised. These factors are known as annuity options and include:
- Joint-and-Last-Survivor
This applies for couples whose income is guaranteed from the annuity as along as one or both partners live. That is; it takes at least a partner for the incomes to continue streaming in even when the other has passed on. However, it is worth noting that adding such an option will affect the incomes negatively and may reduce them by up to around 25%.
- Guaranteed Benefit
This option guarantees a certain number of income payments over the duration of time that may take 5, 10 or 15years. If a partner dies before the planned period comes to an end, the beneficiaries will continue receiving payments until the payment period ends.
- Indexing
This is a flexible option which takes into account the value or rate of inflation. It is drafted in such a way that, as prices of products and services increases, the monthly or annual income that one receives from the annuity also increases. This is logical since price increases in the future will reduce the purchasing power of the income received and hence the need to address inflation. However, such an option might and reduces the monthly or annual income by approximately 30-45%. For instance, to show the impact of inflation, assume an annuity pays $1000 on a monthly basis. If were to assume that inflation rises by 2% every year for the next two years due to the nature of market and the economy, it means that the $1000 in 10 years' time will buy what $820 buys today and $673 in 20 years' time.
Also, assume a couple invests $100000 in an annuity that pays 15.5% annually. The couple is guaranteed $6432 on an annual basis and $536 on a monthly basis on a straight life option. Considering that by adding life plus five-year guarantee reduces the value of the annuity, it means that the couple under the new arrangement will receive $531 monthly and $6372 yearly. On the third option of life plus joint and last survivor, the value of the payment reduces to $435 monthly and $5220 yearly.
Choosing from the options is where now the problem comes in, since the couple does not have any beneficiaries apart from either of the partners. In addition, it is important to note that, since the couple don't want to donate any income to charity when they die, it is inevitable to have some amount left unless the couple passes on at the same time. As such, considering that the couple has no other sources of income apart from their savings from income, it is best to alienate options and advise them to take an index option.
The index option as seen earlier will caution them against inflation and loss of value as years go by assuming that they live on for several years. On the part of having any dependents, the first option, which gives the highest income, fits the bill well. Furthermore, it is advisable to recommend that the couple diversify their portfolio into other funds such as the mutual funds in order to caution them from other unforeseen issues in the future. Unforeseen contingencies may include conditions such as emergency medical bills.
Considering the views above, it is better to advise the couple to take the indexing option since the straight life basis does not address inflation, market risks and life expectancy. The indexing option, though will reduce the amount they will be receiving annually, it will be enough to meet their annual expenses. Assuming that the indexing option reduces the amount due by 25%, the guaranteed $240000 will reduce to $180000 which will still be above what they require. In contrast, instead of investing the whole amount to annuity, the couple should invest $1000000 under the indexing option to guarantee them $120000 annually and invest $600000 in mutual funds to cater for unforeseen contingencies and other expenses.
