Annuity 'income' isn't magic: Most of it is your own money

Q: In a recent column you wrote, "You would need to invest $600,000 to have a life annuity of $40,000." I'm almost 67, mostly retired (due to physical ailments) and have about $500,000 in investments with a Wells Fargo broker. I also receive Social Security of $2,100 a month. I have about $50,000 equity in my house. And those are all the assets I have.

How could I get an annual income on those investments that would approach $30,000 to $35,000 (based on the $600,000 and $40,000 figures you used)? - D.W., Los Angeles

A: The impressive income figure is due to the word "annuity." When you give up your principal in exchange for a monthly income guaranteed for life, you get more monthly cash than you would from investing alone. How can that be? Simple. Much of the money in the monthly check is return of your principal. Annuity payments are based on your estimated life expectancy, plus some yield on your money.

You can play with this by making a visit to immediateannuities.com. The website offers different forms of annuities. If you, as a 67-year-old male, bought a $500,000 life annuity, you would be offered a monthly income around $2,947. (You'll get somewhat different offers from different insurers.) That's a cash flow rate of 7.07 percent.

The cash flow yield is far higher than the yield on typical investments because it's more than yield. It's an estimated return of your principal that you spend as income. The insurance company pays more cash because it's commitment is limited to your lifetime. You have given up your $500,000.

If you were willing to gamble and assume that you will die within, say, 15 years, you could buy a 15-year "period certain" annuity. It would return your $500,000 to you as a series of monthly payments over 15 years. That annuity would be $3,408 a month, a cash flow rate of 8.18 percent. Again, much of the monthly payment would be the (nontaxable) return of your original principal.

Put those figures in a financial calculator, and you'll discover something. The actual yield on your investment during that period is 2.80 percent a year. So you would have more income for 15 years - and then no income. To learn more of this dilemma, Google "The Lotus Eater," a story by W. Somerset Maugham. It's best to get that commitment for a lifetime income!

Q: My wife and I have each been paying on adjustable life insurance policies with face amounts of $100,000 each since 1981. We are both 76 years of age, in reasonably good health, and we both exercise a few times every week. At our advanced age, the cost of this insurance is rising exponentially and becoming quite expensive. Mine is almost $8,000 a year, going up to $10,000 in five years. My wife's policy is over $4,500 per year, going up to almost $7,000 in five years. The cash value of these policies is very small (less than $1,000 each).

Our house is paid for, and we are comfortable living on a small pension, Social Security and monthly withdrawals from investments with a value over $600,000. Should we continue to pay premiums? Or should we cash in these policies? - R.M., by email

A: Life insurance serves a good purpose. It helps us protect those we love from financial losses and hardship in the event of our death. But it's very likely that your policies no longer serve that purpose.

If one of you dies, the survivor will receive the higher of your two Social Security benefits. The survivor will also inherit the house and the full $600,000 in savings. Meanwhile, some expenses will decrease, and the survivor will also have the option of selling the house and moving to shelter that is less expensive and requires less upkeep.

If you examine your current expenses and then compare them to the likely expenses of the surviving spouse, there is a good chance that the survivor's standard of living will remain unchanged. Using ESPlanner software, I have found that a survivor's standard of living can actually increase. So you probably don't need the insurance and are losing $12,500 a year in after-tax purchasing power that you could both enjoy together.

• Scott Burns is a principal of the Plano, Texas-based investment firm AssetBuilder Inc., a registered investment adviser.