On today’s show we’re going to be doing some math. That’s right. The real purpose of today’s show is talk about the importance of financial education. Some people, notably lawyers, mathematicians, accountants, engineers and statisticians will find this math fairly simple.
But for the general population, the inability to perform basic financial math is one of the reasons that wall street and the major insurance companies are able to exploit their customers and quite frankly give them a bad deal on their money.
On today’s show we’re going to look at what some life insurance companies are quoting for income annuities. These financial instruments are often used by people later in life to guarantee an income stream in their later years.
Some of you might be wondering what an income annuity is?
Quite simply an annuity involves paying a fixed lump some of money into an insurance company. The insurance company in turn guarantees you a regular monthly income for the term of the annuity.
There are a couple of different types of annuities. Some are somewhat like a life insurance policy in the sense that the insurance company takes the risk on how long you’re going to live. You might purchase an annuity that has a 10 year minimum on it. But if you live, say, 20 years, the insurance company will take the risk and pay the monthly amount for life.
The second type of annuity is simply a guaranteed income annuity for a fixed number of years without taking life expectancy into account.
So if you call up your friendly insurance company and ask them for a quote, how do you know if you’re getting a good deal?
This is where the ability to perform basic financial math is vitally important. What we’re talking about is the ability to move seamlessly between the present value of a lump sum of money and the future value of an income stream. The most important variable in this instance is what is called the discount rate. That’s essentially equivalent to the interest rate that is being charged for that money into the future.
Now let’s be clear, the calculations to perform this math are extensive if you’re doing it in long hand on a piece of paper.
Fortunately, programs like Excel have a function embedded in them that makes this math quick and easy. But before you can use the function, you need to understand the concept. What I’ve discovered is that a lot of people don’t even understand the concept.
For an investment of 100,000, the insurance company will guarantee you $893 a month for 10 years.
If you multiply $893 a month times 120 months, the total comes to 107,160. So in 10 years, they’re giving only an extra 7,160 for the benefit of holding your money for that length of time.
If you kept the money in your bank account and earned zero interest, simply withdrawing the same $893 a month, the money would run out after 9.3 years instead of 10.
If plug these numbers into Excel, you will find that the insurance company is essentially offering you 1.4% growth of your money on an annual basis. Is 1.4% a good number? I guess it depends. Is it good compared to what?
Compared to the 10 year US treasury yield of 1.549%, it’s a little better, but not by much. The same money invested in 10 year treasuries would give you $900 a month instead of $893 a month from the insurance company. Generally speaking, US Treasuries are considered the safest form of investment.
If you were to invest the money at 6% instead of handing it over to an insurance company, you’d earn a monthly income of $1,110. This is clearly a lot better.
But here’s the sad thing, there are lots of people out there handing their money over to an insurance company to guarantee them an income for life. They don’t have much money to begin with, and the lack of education on how to perform the math is ultimately going to cost them even more money.