Historically, I have also recommended using a future inflation assumption that is 200 basis points below the discount rate as this is roughly the historical difference between inflation and returns on bonds; the investments used in annuity products.
Only the actuaries at the actual insurance companies know the assumptions and methods they use to price their immediate annuity products. These assumptions and methods include mortality, mortality improvement, anti-selection, interest rates and other factors, such as desired levels of insurance company profits, commission schedules and whether they have already written their quota of business for the year. So, I don’t claim to really know the discount rate (or more likely different discount rates by year) assumption they use. I can only make a crude educated guess. Historically in prior posts, I have done that by solving for the discount rate that is approximately consistent with age 65 annuity purchase rates using the age 65 life expectancy for a 65-year old male (22.9 years) or a 65-year old female (24.9 years) under the 2012 Society of Actuaries’ Individual Annuity Mortality Table with 1% per year mortality improvement.
Recently I looked at how much monthly immediate fixed dollar annuity income could be purchased for $100,000 in California by 65-year old males and females from the following three online sources:
The table below shows the highest quoted monthly income for age 65 males and females and the respective implied discount rate for each quote based on the methodology described above.
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As shown in the table, the annuity quotes and implied discount rates from annuityquickquote.com appeared to be significantly higher than those from incomesolutions.com, which, in turn, appeared to be higher than those from immediateannuities.com. The annuity quotes from immediateannuities.com list the actual insurance company and their AM Best rating, while the quotes from the other two online sources do not. For example, the quote from Met Life on immediateannuities.com on September 3rd for a 65-year old male was $490 per month and was $467 per month for a 65-year old female. Under the methodology described above, this translates into about a 2.74% annual discount rate for the male annuity and a 2.84% annual discount rate for the female annuity offered by Met Life.
Based on the data in the table above, I have decided to lower my recommended discount rate and inflation rate by 0.5% to:
- Recommended discount rate: 4.0%
- Recommended inflation rate:2.0%
What are the implications for your spending budget of using a lower assumed discount rate? All things being equal (i.e., your future inflation assumption remains unchanged), it means that your spending budget will decrease somewhat, as the anticipated cost of your retirement will be more expensive. If your assumed inflation assumption is reduced by 50 basis points as well, however, your spending budget may actually increase depending upon how much fixed dollar income you anticipate receiving and how you plan to spread the present value of your future spending budgets.