The Dangers of Buying an Annuity When Interest Rates are Low

Interest rates are the raw material used in manufacturing annuities.  Rates are currently very low--the 10 year treasury note is hovering around 3.4 percent and 30 year mortgage rates are now less than 5 percent.

The financial crisis has led to an upsurge in the sale of fixed annuities.  Fed-up with volatility in the capital markets, many people have sought the apparent safety and stability of fixed payments that are guaranteed.

There are clear dangers, however, to locking-in fixed annuity payments when interest rates are so low. 

First, fixed annuity payments are based on prevailing interest rates.  As a result, today’s fixed annuity purchasers may be buying very expensive annuities unless interest rates remain stable or decrease during the term of the annuity payments.   

Second, any future increase in inflation will erode the purchasing power of an annuity purchased today unless that annuity adjusts for inflation.

As an example, let’s take a look at a hypothetical person named Robert.  Robert is 65 years old and is in relatively good health.  Robert has $100,000 to invest and he wants to buy a single premium immediate annuity (SPIA) that will immediately start providing monthly annuity payments for the remainder of his life in exchange for his $100,000.

The table below shows the amount of the annuity payments Robert can expect to receive for his $100,000 at different interest rate levels—the table starts by showing the payment based on today’s 3.4 percent rates:

To make matters worse, let’s assume that Robert does purchase the SPIA at today’s 3.4 percent interest rate.  Let’s assume that inflation averages 4 percent over the next 10 years.  Robert’s $708 monthly payment will be worth 67.5 percent of what it is today. 

In other words, the purchasing power of Robert’s $708 monthly annuity payment will have eroded by 32.5 percent in just 10 years.  Robert is young and healthy and the SPIA provides payments for the remainder of his lifetime.  As a result, the damaging effects of inflation will would likely persist for much longer than 10 years unless, similar to Japan over the past 20 years, the United States experiences a long and persistent deflation.