What is the actual value of an annuity's guaranteed lifetime income?

Ultimately, this is the key question involved in the purchase of an annuity. They're little more than longevity insurance, though they're rarely pitched as such by salespeople. Consider: Some annuities (e.g., a rider-free variable annuity) offer you next-to-no material benefit relative to many less expensive alternatives other than this guarantee. Others, like fixed and equity-indexed annuities, shave so much return off the top via performance calculations that their other guarantees of minimum returns or fixed rates would struggle to overcome the cost. (See Exhibit 1 for an illustration of hypothetical annuity performance using relatively common assumptions.) In many of these cases, you might as well buy a CD and avoid the complexity.

**Exhibit 1: Index and Hypothetical Annuity Average Annualized Returns (1/1/1995 – 12/31/2012)**

*Source: Fisher Investments Research, UnderstandAnnuities.com, Thomson Reuters, as of 6/4/2013. All indexes and products show total returns with interest and dividends reinvested. Time period chosen due to rarity of equity-indexed annuities prior to 1995.*

So the critical question is, in fact, how much do you value the insurance company guaranteeing you income?

This may seem an impossible thing to quantify, but it's not hard with a little help—if you can quantify how different strategies’ potential returns compare to the annuity’s, you can make an educated decision about the contract’s value.

Planning a future without knowing the full range of likely (and unlikely) scenarios and their probabilities may seem near impossible, but a computer model known as a Monte Carlo Bootstrap simulation can help. Monte Carlo analysis is a widely used tool to determine which asset allocation is optimal for an investor’s long-term objectives.

When we run Monte Carlo simulations for investors, we start by gathering information about you: health; family history of longevity and illness; your goals and income needs and the total portfolio you have to work with today. This helps us determine your investment time horizon and the long-term rate of return necessary to achieve your goals. We then use historical market results—stringing together thousands of combinations of historical market returns—to determine a probability of portfolio survival. Said more simply, we can calculate the odds you outlive your portfolio.

In our view, a correctly configured Monte Carlo analysis should use a very long, broad data set of market returns—like the S&P 500, which can be very accurately calculated back to 1926. Imagine taking a box of 1,044 rubber racquet balls and, on each, writing in permanent marker the monthly percentage change of the S&P 500 composite index for each month from January 1926 through December 2012. Then, throw the balls into a swimming pool. Pick one out at random and write down the return—that’s month one in your simulation. Then throw it back in and pick another for month two, throw it back, and repeat until you have a sample commensurate with your time horizon (which, again, is based on your health, age and family history)—for a 15-year time horizon, you’d have 180 monthly entries, which you’d use to calculate one sequence of hypothetical returns. The Monte Carlo simulation effectively performs this exercise a couple thousand times, while also simulating your expected cash flows and inflation’s impact. This gives you the probability of many portfolio factors, including expected terminal values—for the annuity comparison though, the key comparison is the probability of portfolio survival.

A Monte Carlo analysis is not an ironclad, 100 percent certain guarantee, of course. It will simply provide probabilities you can then weigh against an annuity’s income guarantees. You’ll get a reasonable expectation for whether you truly need an annuity in order to get the income you need over your lifetime—or whether another approach can reach your goals more efficiently. For example, if you enter the parameters and see a 95 percent likelihood your portfolio survives, this would seem to imply the value of guaranteed income is low relative to someone with a much greater likelihood of outliving their savings.

But this isn’t the only factor you should weigh. Your secondary goals and objectives are also important to consider. For example, if you not only plan to draw lifetime income from your portfolio but also wish to leave some to heirs, then an annuity just might not fit with your goals—if you annuitize the contract to receive that guaranteed income stream, you surrender the principal to the insurance provider and thus can’t pass it on.

The annuity's guaranteed income isn't 100 percent certain either. Nothing is. A guarantee issued by a private business is only as ironclad as the business is solvent. One need look little further than Europe, where many pensioners (similar to annuity beneficiaries, called annuitants) have been in the crosshairs of governments seeking cost savings for more than three years. It’s not out of the question annuity owners could be similarly targeted if there were in a similar situation to AIG's 2008 travails sans government bailout.

To know if your annuity's guaranteed income has big value for you—value sufficient to justify the costs—you must know what the alternative actually is. Otherwise, you're likely making an emotional decision. That's no way to approach investing your nest egg. And it's a pitfall too many investors fall into when considering annuities. Don't let buzzwords like "guaranteed" drive you to avoid rationally weighing the pros and cons of using annuities.

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HT: Read Price.

*1. Blended index consists of 70% S&P 500 and 30% Merrill Lynch 7-10 Year US Treasury Index.*

*2. Hypothetical variable annuity assumes the above blended index, less annual variable annuity expenses of 3.98%. The assumed annual expenses include Mortality & Expense Risk of 1.25%, Administrative Fees of 0.15%, optional Guaranteed Minimum Death Benefit (GMDB) of 0.61%, optional Guaranteed Lifetime Withdrawal Benefit (GLWB) of 1.03%, and Fund Expense for underlying funds in a variable annuity of 0.94%. Charges are based on the Insured Retirement Institute’s 2011 IRI Fact Book, pp. 36-38, 56.*

*3. Hypothetical equity-indexed annuity assumes an investment in the S&P 500 with a 100% participation rate, 8% cap and 1% floor, less annual annuity expenses of 1%.*

*4. Hypothetical fixed annuity return is equivalent to the average 10-year Treasury rate from 1/1/1995 – 12/31/1995.*

*This constitutes the views, opinions and commentary of the author as of July 2013 and should not be regarded as personal investment advice. No assurances are made the author will continue to hold these views, which may change at any time without notice. No assurances are made regarding the accuracy of any forecast made. Past performance is no guarantee of future results. Investing in stock markets involves the risk of loss.*

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*The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer*

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