July 22, 2014

How much money do I need to provide a good income?

Only you know what a good income is for you. We’ll make an assumption here that you would like an annuity that will provide a monthly income of $2000. We would recommend that you don’t invest all of the lump sum you have saved in a single annuity with a single company. If you can, buy annuities from more than one insurance company. It’s a good idea not to keep all of your eggs in one basket.

For several years, much of the world has been living in a low interest rate environment. The Federal Reserve has pledged to keep American interest rates low until at least the end of 2014. Until there is strong economic recovery, low interest rates are likely to persist.

In a low interest rate regime, you will need to have saved hard while you were earning money, because a big lump-sum is needed to buy an annuity that pays a good income.

Typical Annuity Payout Rates

A 62 year-old man buying a fixed life annuity for himself in 2012 could expect a payout rate of about 6.5%. If the man were 70 years old, the rate would increase to about 7.8%.

Women can expect lower payout rates, because they live longer, on average. A 62 year-old woman buying a fixed life annuity for herself might expect a payout rate of 6.1% and a 70 year-old could expect about 7.1% in 2012.

Examples of Annuity Incomes

An annuity payout rate of 6.5% provides a gross income of $542 a month for each $100,000 of lump sum you invest.

For a gross income of $2000 a month you’d need to have built up $369,000 of funds to buy your annuity.

Insurance companies can offer annuity payout rates higher than typical interest rates, because, in addition to interest, your monthly payments are funded by paying you back some of the money you bought the annuity with. In technical jargon, your monthly payments are funded with interest and part of the principal.

Annuity Payouts are Higher than Bank Interest Rates

Annuity vs Bank Account Payout

The principal is returned tax-free. The interest gain is taxed as ordinary income – this is the first time the interest will have been taxed. Interest is not taxed until money is distributed from the annuity. (See Tax Deferral on Annuities to see how this increases your payouts).

Inflation-proof annuities

Let’s say you plan to retire at 62. Lucky you! You would like to get an income of $2000 a month from your annuity. Let’s also say that real-world annual inflation averages 4%.

Sadly, in these circumstances, by the time you reach 75 your purchasing power will have plummeted to just $1176 in today’s dollars.

If this worries you, you could buy an annuity whose payout rises each year by a few percent.

The drawback of such an inflation-adjusted annuity is a lower initial payout.

If you were offered a 6.5% payout with no inflation-adjustment, you might expect something like a 4.6% initial payout from an inflation-adjusted annuity, with payouts rising by say 3% each year.

To obtain $2000 of inflation-adjusted monthly income, you would need to pay about $522,000 for your annuity. You can see from this type of number why financial advisers are always telling us we need to start saving for our retirement when we’re young. Unfortunately, most of us still seem to ignore this advice.