If you buy an annuity for $100,000, and it pays $6000 per year, that seems like a 6% return. But that’s not actually the interest being paid. Most of each payment is just your own money returned to you. Here I try to work out what interest rate an annuity actually pays.
To do this, I worked out what interest rate the insurance company would have to make to exactly cover all the payments to a large group of people who buy the same annuity. For that I needed actuarial tables that predict how many people will live to each age. I used data from Statistics Canada. Note that this is not the same as just using average life expectancy; I actually assume the insurance company keeps making payments to remaining survivors each year.
There are many types of annuities. Here I focus on the simple case where there is no guarantee period, which means that the payments stop when you die, even if that happens shortly after buying the annuity. I also looked only at single person annuities with level payments (no increases to account for inflation). I repeated the calculations for males and females of ages 60, 65, 70, and 75.
The following chart shows the results. To use this chart, take the annuity payout percentage and find it on the vertical axis. Then see where it meets the appropriate chart line to find the interest rate on the horizontal axis. For example, RBC’s Annuity Calculator tells me that a 70-year old man in Ontario would have to pay $313,820 to get $2000 per month ($24,000 per year) for the rest of his life. This is a payout of 7.65%. The chart says the insurance company needs to earn 1.6% per year on the man’s lump sum to break even.
Of course, this 70-year old man is getting more than just 1.6% interest. He’s also being freed from longevity risk. Well, maybe he’s just being partially freed. After all, the real value of his payments will decline with inflation over the years. Even with the reduced longevity risk, 1.6% interest seems quite dismal. That’s unlikely to keep up with inflation.
I like the idea of reducing longevity risk, but the payouts on annuities just seem way too low. You can see this more clearly if you look at annuities that increase payments every year to account for inflation. The starting payments on these annuities are much lower.
This is just one more example of how you have to sacrifice returns to eliminate risk.