AN AARP TALE: "THE PAYOUT RATE VS. THE INTEREST RATE"
Carlos M. Sera, MBA
September 2, 2015
My 85 year old father recently received a solicitation from AARP. For those that may not know about AARP, it stands for the American Association of Retired Persons. He showed me the solicitation letter and since we both thought the offer looked tempting, we did exactly what the letter instructed and asked AARP to send us more information. We were particularly intrigued about how my father could
1) Receive 9% a year for the rest of his life,
2) Never outlive this 9%, and;
3) How my mom would receive any leftover money that he might not get if he were to die before he received an amount equal to his original investment.
I had a pretty good idea of what AARP would send, but ever the optimists, we waited with anticipation and a week and a half later we received the “magic solution.” If you scroll to end of this tale, you can see the “magic solution” my father received from AARP.
Many know by now that what they were asking my father to invest $50,000 into is called an immediate annuity. However, I like “magic solution” much better since like the alchemist of old, AARP and their preferred vendor New York Life are trying to make you think they can convert a less than 1% world into a 9% dream. This fantasy of getting something for nothing is obviously the image AARP and New York Life wants to imprint in your brain. Many people might say things like “shame on them” for trying to deceive the unsuspecting consumer. Many might say things like “the government should do something about this and protect the innocent.” I say, and the reason I write Financial Tales–you must protect yourself. Ignorance is not an excuse. Learn the facts and learn that when dealing with anyone or any product that offers you a stream of guaranteed income for life that what they typically try to sell you is called “The Payout Rate” and if you don’t understand simple math you will confuse it with “The Interest Rate.” The two are not the same and it is a vital lesson for anyone contemplating giving money to an insurance company or an esteemed organization like AARP. It is the reason the subtitle of this tale is The Payout Rate vs. The Interest Rate.
Let me digress before I continue with this tale. Some of you may have read A Lumpy Tale. Essentially it answers the question—Should I take a lump sum amount at retirement or a stream of income for life? The circumstance in this tale where my father could invest $50,000 in exchange for an income stream for life is the same analysis. So I suggest you read it as well. If you don’t let me summarize, in A Lumpy Tale in many cases I recommend that a person about to retire that has never saved money in their life should avoid taking a lump sum. I know this is heresy to the mainstream financial planning community and investment advisory community but they are flat out wrong. They don’t factor client behavior and habits into the equation. I recommend this course of action for these types of savings-challenged people because if a person hasn’t saved money by the time they go to retire and someone hands them a Lump Sum of money they will more than likely blow it. Remember these tales are meant to impart wisdom and often go against mainstream financial planning. Nevertheless, it is instructive for those on the verge of retirement to understand the difference between The Payout Rate and The Interest Rate.
Let’s see just how AARP works their magic by providing a 9% rate in what I consider a 1% environment. I think everyone would like to know how they do it, so let’s sum up their offer and then examine if it is a good investment or not. Here’s what they offer. If my 85 year old father invests $50,000 into the “magic solution,” they will guarantee him $4,500 per year for the rest of his life no matter what. If he dies at age 86 and has received one payment of $4,500, my mom will get $45,500 back. If he dies at age 87 after receiving 2 payments of $4,500 for a total of $9,000 over two years, my mom gets $41,000 back. This goes on like this until he eventually dies. If he lives to age 97 he would have received $54,000 by then and if he dies my mom would receive $0.
So let’s analyze the “magic solution” and as always compare it to alternatives. Let’s first compare the “magic solution” to investing cash under your mattress. If my father took $50,000 and put it under his mattress he could take out $4,500 at age 86 and if he died my mom would find $45,500 left under the mattress—the exact same as with the “magic solution.” If he took out an additional $4,500 at age 87 and then died my mom would find $41,000 left under the mattress—once again the exact same number as the “magic solution.” This could go on for many years and in fact until my father reaches age 96. At that point there would only be $500 left for my mom should he die—and once again, the exact same amount as under the “magic solution.” So the analysis is simple—if putting money under you mattress gives you a 0% rate of return for 11 years and the “magic solution” does the same, then the “magic solution” is also making you a 0% rate of return over the same time period and equivalent to mattress investing. This is not a very good investment in my opinion. In fact I think it’s terrible. However, they are paying you $4500 per year which is a 9% payout rate on the $50,000 investment. That’s the point of this tale. They are taking your own money and in a legal variation of a Ponzi Scheme they are giving it right back to you for 11 years.
It’s beyond my imagination to think that with the intense scrutiny of financial regulation aimed at protecting the consumer, a coordinated effort on a national level could exist where it appears to me the sole objective is to—- imprint a 9% return into the minds of the unsuspecting when for the first 11 years of the investment the real return is no better than putting money under a mattress. This simply can’t be. I must be missing something. After all we are talking about AARP and New York Life. These are reputable and esteemed firms.
So I ask, what might be behind this offer that I can’t see. For example, what happens if my dad lives more than 11 years? Let’s say he lives to 100. By then he would have received 15 payments of $4,500 or $67.500 which is $17,500 more than he invested so all is not lost. The expected value of this investment is in fact not 0% but something higher since in fact some 85 year olds that enter into the “magic solution” contract with New York Life under the blessing of AARP will in fact live beyond the age of 96 and in fact actually make some return on their $50,000 initial investment. So I ask the question, how long would my father have to live in order to achieve a 9% rate of return on his investment instead of a 9% payout rate?
The answer is he would have to live to age 114. By then he would have received 29 payments of $4,500 each or a total of $130,500. Though my father is very healthy and exercises regularly. I couldn’t recommend he invest $50,000 into the “magic solution.” It doesn’t make sense to me to make a 0% return on money for 11 years. It may make sense to some but not to me.