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Convert your annuities to hard assets

Posted by John Reed on

Copyright 2015 by John T. Reed

An annuity is an amount of money you receive—usually monthly—until you die. Social Security is a classic example of an annuity.

When they had their famous hyperinflation in Germany in the early 1920s, and they used wheelbarrows of cash to buy groceries, who was hurt most? Annuitants. Pensioners. People receiving pensions payments. I discuss that in detail in my book How to Protect Your Life Savings from Hyperinflation & Depression, 2nd edition



The problem with an annuity in hyperinflation is that it is a dollar-denominated asset or income stream. Those assets or income streams become worthless during hyperinflation.

COLA works too slow to help you

Do you think you are protected against inflation by the annual cost of living adjustment (COLA) in the amount you get paid? If so, you’re wrong. Basically, the timing of the COLA is too infrequent (annual) and has too much of a lag (about 90 days) to handle high inflation.

The adjustment is in December or January. So what happens to you during the eleven months after the adjustment before the next adjustment? The purchasing power of your monthly payment falls further and further behind current rising prices.

Plus, when they do make the adjustment at the end of the year, they only bring you up to the prices of three months or so ago. During hyperinflation, a fortune can become a pittance in 90 days. So the typical COLA—only one annual adjustment and 90-day lag when it happens—never catches you up to inflation—unless inflation ends and the same currency is still being used.

There is disinflation, but there is no dis-hyperinflation

But it never happens that way. We had inflation in the late 1970s and early 1980s. Then, because of President Reagan and Fed Chair Paul Volcker raising interest rates to stop high inflation, we had disinflation. The inflation subsided. It went away.

But there has never been any such thing as dis-hyperinflation in the long history of hyperinflations.

Hyperinflation always ends. It always ends overnight. And it always ends with the death of the currency in question.

Sometimes the country in question issues a new currency to replace the old—like the German rentenmark that replaced the hyperinflated deutschemark in 1923. Other times, the old currency dies but it is not replaced by a new currency issued by that country. They just tell their citizens to use the currencies of other countries. That is what happened in Zimbabwe in 2009. They still don’t have a new national currency. Lots of countries don’t. Most of them use the USD, a policy called dollarization.

Government will protect you? Forget about it.

Surely, you think if the U.S. dollar (USD) dies, the U.S. government will start paying your annuity in the new currency or in some other foreign good currency.

Where will the U.S. government get the money to do that? The whole reason hyperinflation happens is the federal government cannot tax or borrow enough money to keep all the financial promises it made. So they print the money. That causes it to hyperinflate.

The currency dying does not change that. As a practical matter, what happened in Germany after the deutschemark died was the government, after a delay, starting making some new, token pension payments and bond interest payments. Something like 5% of the prior amount if I recall correctly.

In short, if we get hyperinflation in the USD, and you own USD denominated assets or a USD-denominated annuity like social security or a pension, your USD-denominated asset and/or annuity will become worthless. After the crisis is over, you may get some token compensation for your loss from the new crop of politicians, but essentially, if you have USD-denominated annuities when the ’flation hits the fan, you’re screwed.

Can you do anything about this now?

Take the lump sum

Yeah. First, in many cases, you can accept a lump-sum instead of an annuity. This is true with private pensions, some government pensions, state lotteries, and many lawsuit settlements. I do not believe it’s true of social security or military pensions.

Generally, you should take the lump sum because you can put it into hard assets (which are protected from hyperinflation by definition) or foreign currencies (which are protected from USD hyperinflation but not their own hyperinflation). In some cases, the lump sum may be too low in relation to the amount of the annuity. Telling when that is requires complex time-value-of-money calculations that are beyond the scope of this article and in any event require a bunch of assumptions.

Here, I will just say that a lump sum is a bird in the hand and an annuity is a bird in the bush. And as we know, a bird in the hand is worth two in the bush. So there’s a very crude “calculation” for comparing the two.

How about an annuity in kind?

An annuity in kind is not a USD- or any other currency-denominated annuity. It is denominated in goods or services.

I know a lady who sued a hospital. They offered a lump sum of money. She insisted on lifetime care from that hospital for the problem in question. They agreed. That turned out to be a wise move and she has been going back there regularly ever since. Because that annuity is denominated in services, not a currency, it is unaffected by inflation.

Another sort of annuity denominated in services is a life estate. That is the right to live in or rent or whatever an asset, most commonly a home. You get to live there or rent it out or whatever you want to do with it other than let it deteriorate until you die. So if there were extremely high inflation, the rental market value of that place would skyrocket, but it wouldn’t bother you because you have the right to live there rent-free until you die no matter how much the remainderman (the person who gets full title when you die) could rent it for during the hyperinflation or after.

There have been other in-kind annuities, like free air travel on a particular airline for the rest of your life.

Now you probably are recognizing that annuities in kind can have another risk called credit risk. That is, the risk that the entity paying you the annuity in kind will stop paying, that is, be unable or unwilling to keep on paying or serving you. Like the hospital I just mentioned could shut down or go bankrupt. Or the airline in question go go bankrupt. Of course, that’s also true of annuities like social security and federal pensions.

But with a life estate, there would not be credit risk. You already have possession of the home or other assets. The remainderman does not have to do anything each month so their ability or willingness to do anything is a non-issue.

But there are some other obligations that you have in a life estate. You have to pay the property taxes, insurance, repairs, homeowners dues, and all that kind of stuff. If you have trouble doing that in hyperinflation, which is possible if you have no substantial income, you could theoretically rent the place out for current fair market rental value and thereby get the money to cover those expenses. But that might leave you homeless.

Or you could have problems like rent control—which is almost universal during hyperinflation—which would hold your rents down more than your expenses. Landlords, which is what you would suddenly become, are evil you know.

You could also sell your life estate, in theory. If you sold it to an owner occupant, they would not care about rent control. That lump-sum sale proceeds could help you pay for a new place to live.

But in general, you are infinitely better off with an annuity in kind like a life estate than with a currency-denominated annuity like social security during hyperinflation.

H.E.C.M.

The home equity conversion mortgage (H.E.C.M.—often misnamed a reverse annuity mortgage) gives you a sort of life estate. It has no payments. You can take, and should take, a lump sum instead of the monthly cash annuity. You then put that into some hard asset or diversified foreign-currency portfolio.

One difference from a life estate per se is that if you move out for more than a year, you are forced to pay off the H.E.C.M. even if you are still alive. Typically, that would be your moving into a nursing home because you can no longer take care of yourself adequately to live in a regular home.

So how about this?

So how about this as a way to, sort of, convert your annuity into a hard asset?

Borrow an amount—probably best in the form of a mortgage—such that the monthly payment on the loan matches the monthly amount of the annuity. Like my social security is $2,570 a month, so I could buy a property with a mortgage where the monthly mortgage payment was, say, $2,500 a month.

In the event of a depression, which is deflation, I would normally have trouble making the mortgage payments, but not in this case because my social security check would cover it. There is the credit risk of the federal government not sending me the check, but as long as they did, I would have the money to make the payments in spite of my income from my business likely going down during a depression.

And in the event of hyperinflation, my social security check would cover the mortgage payment, although it would become easy to pay in any event. The monthly mortgage amount would become like the price of a candy bar. But the hard asset I had bought with the mortgage loan proceeds—the real estate—would skyrocket in USD value and I would make both a nominal—before adjusting for inflation—and a real—after adjusting for inflation—profit (because of leverage).

The lack of symmetry in these two situations compels choice #2

Now look at the situation in each case:

1. You just keep on collecting the USD-denominated annuity and hoping there is no hyperinflation in the USD

2. You buy real estate with a mortgage the payment on which is equal to or less than the after-tax amount of the monthly annuity payment you receive

In depression/deflation, choice #1 makes you a little real return as the purchasing power of your annuity goes up due to deflation.

In hyperinflation, choice #1 means your annuity becomes worthless!

In depression/deflation, choice #2 leaves your situation unchanged except your equity will decline and maybe disappear.

In hyperinflation, choice #2 means you make out like a bandit in real terms (even after adjustment for inflation) because the USD value of your real estate skyrockets, and you are leveraged, but the mortgage stays the same and is covered by the annuity payment you receive.

Choice #1: chance of small increase in purchasing power in the event of deflation and disaster in the event of inflation—limited upside; total loss downside

Choice #2: chance of loss of equity in the event of deflation or explosion in value of equity in the event of high inflation— Unlimited upside; limited downside.

Is there some free lunch operating here? No. There is no free lunch here or anywhere else.

What’s going on is you are hedging against high inflation in choice #2 and the lender is getting screwed for betting on no inflation (by making a fixed-rate mortgage) and losing. In choice #1, both you and the lender are risking equity in the event of deflation—more you than they. But in the event of inflation, you are risking total loss of principal if you just keeping getting monthly payments of it—which would be a great deal for the U.S. government or other payer of the annuity, plus they are in charge of preventing or causing the hyperinflation!!

Non-recourse mortgage?

If the mortgage were non-recourse, which is the case with the H.E.C.M. (an FHA mortgage), you could only lose your equity, not any other assets or income. There are other non-recourse mortgages—like purchase-money, conventional mortgages on owner-occupied homes in CA and AZ. In recourse mortgage, if the property were foreclosed, and did not produce enough at the foreclosure auction to pay off the loan, the lender could go after your other assets and income possibly. It varies by state law and the contract language. But how could a foreclosure happen with that annuity payment coming in each month to make the mortgage payment?

If the mortgage became under water, you might choose to stop making the payments, especially if the loan were non-recourse. Then you get to keep the whole annuity amount each month which would have greater purchasing power than before the depression/deflation started.

There are some other complications like you need to calculate all this on an after-tax basis. My social security is taxable so I would need to use only the after-tax income from it as the measure of how big a mortgage payment I could handle.

In my case, and in the case of many readers, it might make sense to do something like this. We have three sons. One already owns a home. The other two rent. How about we buy a home or two jointly with the sons as tenants in common (they work 400 miles apart so it would only be one son per home). We get a mortgage on each home. The son pays rent to us for the percentage of the home we own—which is standard common law, not my being a tough guy. Our portion of the mortgage payment is covered by one or more of our annuities. We are not landlords in the general sense of the word. No stranger is living in our property.

In short, we have sort of converted our annuities, which are at extreme risk for becoming worthless in the event of hyperinflation of the USD, into hard assets, which retain their real purchasing power during inflation, and which, when leveraged, produce huge real returns.

Leverage

Leverage means borrowed money. For example, say you put $200,000 down on a $1,000,000 property and borrow $800,000. High inflation hits and the property value rises to $1,300,000. The mortgage remains $800,000, so your equity jumps up to $500,000. 30% inflation on the property value results in a 250% increase in your equity value.

That’s leverage. It leaves you ahead—big time—even after you adjust your new equity amount for inflation.

Liquidity

You need a certain amount of liquidity. That is net worth in the form of liquid assets like foreign currency or US currency with a high face value to melt value ratio (nickel and penny). So you must avoid putting too much into real estate. I recommend having enough liquid assets in rainy day savings to live off of for 6 months to two years. I have put about that much into foreign savings accounts abroad. Also real estate that you use, like a home, is different from real estate that you rent out. You need liquidity to pay the monthly expenses of owning a home. Owning it free and clear or with a low loan-to-value ration reduces your need for liquidity.

Change of mind or ability to own home

If you buy a home jointly with a relative as suggested above, there is a risk that the relative will need to move out or want to move out in which case the home will suddenly became less trouble free.

In theory, you could be a less troublesome asset that you pledge as security for the mortgage, like U.S. nickels stored in a vault in the control of the lender, but I am not familiar with the procedures for doing that or the availability of such loans. I know that last year there were some scandals involving loans against copper where it became known that the same copper had been pledged to more than one bank as collateral for multiple loans. The bank controlling it in their vault would fix that.

Normal risks of real estate

There are a number of normal risks of real estate and you would need to beware of them, like litigation, toxic contamination, overbuilding, political risk (anti-real estate laws being enacted), casualty loss, obsolescence, wars/riots/revolutions.

If you are happy with your annuity, you implicitly are saying you believe inflation will be zero until you die

If there is no inflation at all during the rest of your life, the straight annuity is a better deal than trying to convert the annuity into a lump sum by borrowing against the annuity income stream—because you pay no interest. But the U.S. Federal Reserve Bank is in charge of inflation and their target inflation rate is 2%. In December 2014, it took $234.81 to buy what $10.00 bought in 1913, the first year they counted the Consumer Price Index and the year the Fed started controlling it. So if you continue to get an annuity and do not try to convert it into hard assets or foreign currency, you are implicitly saying that the rest of your life will be a period when what $10 buys today will be the same as $10 buys every year in the future until you die. That has not happened in over a century.

If you are happy with your indexed annuity, you are implicitly saying the annual increase you get in your annuity is equal to the annual increase in your living expenses—it’s not

With the rare indexed annuity (social security and some federal pensions), you are saying the loss of purchasing power will be zero after the indexing but that would only be true if the indexing were done monthly, not annually, and if there was no 90-day lag in the collecting of data and calculating of the adjustment. See this article: “The COLA Crunch: Why Social Security Isn’t Keeping Up With Inflation.” So you are a little better off with an indexed annuity, but not enough to make the annuity worth waiting for.

So please tell me the flaw in this if you can find one.

Here is a reader email and my answer:

Dear Mr. Reed,

I read your latest article with interest but considering the fact that when hyperinflation ends, it ends overnight and it ends with the death of the currency in question, can you address a couple of questions?

1. If the currency in question is now "dead", don't the paper profits of your real estate die with it?

2. In reality, would you not have to sell before the end of the hyperinflated market in order to realize any gain?

3. If you could not time the end and a new currency is put in place, is there really any certainty you'd have a gain at all? Compared to what?

Clearly, you'd be in better shape having the hard asset rather than worthless old currency but am I missing something about realizing the gain?

I suppose you'd see the gain if we had something less than hyperinflation and it was brought under control similar to how it happened in the 80's and you were then able to sell the asset and realize the gain in the existing currency.

No. Debtors make out like bandits in hyperinflation, especially debtors who own mortgaged hard assets like rental properties, businesses, and farms. Collateral allows you to borrow far more and thereby make far more when the debt becomes worthless.
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Your statement that you make money out of the tenants is mostly wrong. In recent decades, most money in real estate has been made out of property appreciation which in turn came from shrinking cap rates. That is, buyers were willing to accept less and less cash return because they believed more and more in appreciation. The appreciation far outstripped the increases in net income.
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My book How to Protect Your Life Savings from Hyperinflation & Depression, 2nd edition explains this in detail. It’s too complex overall to explain here. Look at the table of contents which is online and you’ll see what I mean. http://www.johntreed.com/hyperinflationdepression.html

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