The U.S. Treasury Department has recently proposed new rules encouraging retirees to devote at least a part of their retirement accounts to immediate annuities. An immediate annuity is a life insurance contract that guarantees a stream of income payments in exchange for an up-front payment. The idea behind the proposal is to assure retirees that they won’t outlive their savings, since the annuity will make the contractual payments no matter how long the retiree lives.
To generate an example under the proposed regulations, I went to Berkshire Hathaway’s EZQuote website and entered four items of information: state of residence: California; date of birth: February 1, 1947 (age 65); gender: female; and amount of deposit: $100,000. The result was a quote of $479 per month for a “single life” annuity. If the proposed annuitant dies one year after starting the annuity, she will receive only 12 payments totaling $5,748. If she lives to 100, she would receive a total of $201,180. The Berkshire Hathaway website notes that our retiree is earning a return of 2.44 percent annually (for life). Whether that seems like a good deal to our proposed annuitant will depend heavily on how long she thinks she’ll live.
According to Treasury Secretary Geithner, the new regulations will provide 401(k) participants the “ability to choose from expanded options [that] will help retirees and their families achieve both greater value and security.” I find Geithner’s comment disingenuous, coming at a time when the policy of financial repression engineered by the Treasury and its handmaidens at the Federal Reserve is making it impossible for retirees to achieve “greater value and security.”
“Financial repression” (see my January 2012 column) consists of conscious federal fiscal and monetary policies designed to lower returns on debt obligations of all maturities to rates below the rate of inflation. The policy’s purpose is to reduce the interest cost of the federal government’s endless borrowing so that it doesn’t completely overwhelm the federal budget.
Nowhere will the harmful impact of financial repression be greater than in the insurance business. And nowhere in the insurance business will that impact be more apparent than in its annuity offerings.
The insurance company looks at annuitants through the lens of the “law of large numbers,” which says the larger a pool of annuitants it can assemble, the more likely the whole pool will behave in accordance with actuarial averages. With a large pool of annuitants, the insurer can then predict pretty well how many will die each year and, with that prediction, can estimate its liabilities to annuitants over time.
But the insurance company doesn’t just put those up-front payments from its annuitants in a giant piggy bank and dole them out as needed. And it cannot legally print money. It has to generate some income on the annuity pool to pay its actuaries, its clerks, and especially its sales people. And generate some return on capital.
Traditionally, the funds to run an insurance company have come from investing its insurance pools, including annuity pools, in bonds. The insurance company uses the bond interest left over after paying the help and the shareholders to pay a return to the annuitants. If a policy of financial repression lowers bond interest rates, the entire difference will come out of annuitants’ returns, because the insurance company still needs to pay the help, and if there’s no return for shareholders, the company will exit the annuity business.
How does this affect those wishing to purchase an annuity so their retirement income won’t run out before they do? Let’s look at a new retiree who fits the profile I entered into the EZQuote website. With the annual return information of 2.44 percent in hand, it’s a simple matter with an Excel spreadsheet to calculate that Berkshire Hathaway is assuming an actuarial life expectancy of 21.9 years, meaning the odds are even that our proposed retiree will live to just shy of age 87.
In an interest rate environment not dominated by a fiscal and monetary policy of financial repression, we might find Berkshire Hathaway offering 4.44 percent instead of 2.44 percent to its annuitants. Again using our spreadsheet, we’d find our retiree being offered $579 per month instead of $479. In effect, our retiree will be paying a retirement tax of $1,200 on top of the federal and state income taxes she’ll pay on the $5,748 in annual income she’ll receive.
Of course, $479 per month won’t go very far in meeting our retiree’s living expenses. If she needs $2,000 per month above her social security payments, she’ll have to commit $417,500 from her IRA or 401(k), assuming she has that much. Her “retirement tax” will be $418 per month, or $5,000 a year. That works out to more than $100,000 over her 21.9-year life expectancy.
My advice in January to stay away from long-term bonds, CDs and annuities as long as the feds are pursuing a policy of financial repression applies in spades with respect to retirement annuities.
Now to rub some salt in the wound. California applies a “premium tax” to purchases of immediate annuities. In our EZQuote results, we see the state will take $2,350 out of the proposed $100,000 our retiree invests. This lowers her monthly income stream by $12 for every $100,000 she invests, or $3,154 over her actuarial life expectancy, and represents another retirement tax on those who, for the most part, can’t afford it. If the Treasury is serious about encouraging annuities to generate retirement incomes, it’s time for them to forbid the imposition of state premium taxes on them.
To paraphrase a ’60s radical slogan, if you aren’t outraged by what financial repression is doing to savers, particularly those entering retirement, you aren’t paying attention.
