Are annuities the best way of generating monthly income?

Question

What is the most effective, least costly, way of generating monthly income from an investment of $500,000 or more? Are annuities too costly?

Answer 1

It is definitely not the least costly if you are looking at it in terms of generating $X in income per month per $Y invested. The benefit of Annuities is that they are one of the least RISKY investments. Unless the company you bought them with defaults you get a guaranteed income stream even if we experience an extended bear market.

For that safety you likely give up some return compared to just investing in cash-flowing investments. What you are buying is that risk reduction.

In a nutshell you are buying insurance to protect your income stream.

Answer 2

If you need the income to last for life (of an individual or couple) but no longer, then an annuity is likely the best option. This is because an insurance company can diversify your longevity risk with that of other customers. Investments you make on your own would not be able to hedge your longevity (you're facing a sample of 1); you couldn't spend as if you'll die at 80, because you might live to 105.

Answer 3

Another consideration when looking at the cost of annuities is how regular your income needs are.

In the UK, annuities are taxed as income. If your income needs tend to fluctuate over a year, you may find that you are getting an annuity income every month that you may not need in its entirety, but you will still get taxed on that income.

If you are just pulling income out of investments or an drawdown scheme, then they may still be taxable, but at least you only pay tax on income that is actually necessary.

A reasonable approach may be to blend your income approach - purchase an annuity to cover that income that is essential to you (getting the benefit of the guarantee for life) and then draw income from other sources as and when you needed to cover life's little luxuries.

N.B. A lot of this depends on how much income you are looking for and how much tax you might wind up paying - everyone's circumstances are different.

Answer 4

In addition to the considerations others have mentioned, you also have to take inflation into account. Some annuities are fixed, some may be indexed to the CPI, but even those aren't necessarily indexed to medical inflation or housing inflation or some other expenses that may rise dramatically over your lifetime.

For an example, assume you are a man age 65 today, and your annuity starts paying $30,000 immediately. You have a remaining life expectancy of approximately 18 years (in the US), or until 2038.

Now let's look at inflation over the past 18 years (remember, past performance is no indication of future results, but absent a crystal ball, it's the best data we have available). One dollar in 2002 bought as much as $1.43 today. Or said differently, your standard of living will decrease substantially. By the time you pass on, your standard of living will be whatever you can afford with approximately $21,000.