finance a la shmoop. what is an annuity? a new it tea? maybe like you know the ones
that Instagram models advertise. yeah those. no it's not new. but the a new [picture of tea]
thing there at the beginning of the word no nothing to do with proctology. get
your head out of there. the ANU is short for annual- and that's the kind of you
know derivative of the word there that applies. an annuity is a kind of weird
insurance policy with hundreds of twists and flavors and special options
investors can buy. let's say that the wonderful Cathy clueless invests a 100
grand in an annuity when she's 52 years old and she does nothing. from the way
the annuity contract is set up when she the investor turns 72 which is when she
plans to fully retire from her career as a professional interpretive dancer, she
can withdraw a thousand dollars a month for as long as she lives. so you think
hmm this is a weird shell game right? well she put in a hundred grand 20 years
earlier and now she gets a grand a month for as long as she lives. well how long
will she live? and what happened to that hundred grand ?it was that a good deal or
a bad deal ?well first things first the insurance company will likely have a [man frowns]
decent actuarial table to estimate how long interpretive dancers live. that is
they take data on factors like you know how often Cathy goes to CrossFit, whether
she engages in healthy habits like texting and driving, and you know the
food she eats and if she takes part in any dangerous activities like you know
skydiving. and well then they estimate and she lived to be 90 that is she'll
live 18 years after age 72 which is when she starts getting that grand a month or
eighteen times 12 and yes we're gonna ignore time value money here for a
moment. that equals 216 months of collecting a
grand a month from her annuity and you may think all those insurance companies
they're suckers. they made a bad deal. but then you look at their nice collection
of jets and buildings and your probably wrong yeah. well they only took
in a hundred grand and they have to pay out two hundred sixteen thousand dollars? [equation]
well yeah let's go back to the offices. there of fools gold insurance. do they
look like suckers no actually give suckers to buyers, but that's a different.
story so forensicly we go back to the original hundred grand that Kathy gave
to the insurance company. remember that rule of 72? yeah that one .will you take
the compound interest rate at which some investment grows, divided into 72 and
that's how long it takes to double. well the insurance company has historically
invested in a combo of stocks bonds real estate hedge funds and other things, such
that it gets about 7.2 percent a year return with a relatively safe portfolio.
so then if Kathy clueless invested 100 grand at age 52 ie handed over that [annuity math explained]
hundred grand to the insurance company so it's all theirs, yep then when we
divide that 7.2 into 72 and it's 10 meaning it takes 10 years
for that money to double. so it'll double by the time Cathy's 62 ,that hundred
grand goes to 200 grand when she's 62, and it still has another decade of
compounding before she even touches. it so let's do another rule of 72 doubling,
with that 7.2 thing in yeah that 200k has compounded again to double and be
worth 400 grand to the insurance company by the time Kathy is 72 and then begins
to withdraw cash, well to keep the math simpler let's forget the monthly numbers [ATM machine spits out money]
and just note that she takes out $12,000 a year now right? well that's 12 months
times a grand a month and well that 400 grand continues to compound again it's
7.2 percent. that is it grows in value in year 1 at about 29 grand. and the
insurance company only has to pay Kathy clueless $12,000 a year, so at the end of
year 1 her account is worth 429 K minus 12 K or about 417,000$. that is even
with a grand a month payout her account value grew and with compounding each
year it will grow more than it did the year before and she'll be withdrawing
way less money than the principal will have grown. if she lives to a hundred
fifteen the insurance company will still have done well because in this
particular policy they keep the money at the end.
now some policies have a life insurance kicker like had she died before she was
72 her grandkids would get a half a million dollar payout, or her original
hundred grand would be distributed to her heirs ,or the save-the-whales
foundation, or something like that. or there'd be some other twist and turn
that makes the annuity complex and hard to figure out from a mathematics
perspective for non professionals and the insurance biz. adding to the friction [woman is lost driving down the road]
is the fact that there are usually very high commissions and fees charged to
people like Cathy clueless. note her last name there. and they don't realize that
if they had just been disciplined and put that original hundred grand in an
index fund and forgotten about it well, they'd have come out vastly better than
buying that annuity. so why do people buy annuities in the first place? well why
did people invest in Enron and bad real estate in places and you know some
people just aren't financially literate enough to make wise decisions about
their future and they end up investing for retirement in an inefficient vehicle
like an annuity and you know talk about bad fuel economy and stuff like that. [ car smokes as it is driven]
they have good brokers though who really know how to make a commission selling
him maybe they should have watched this video right?