Avoid this common investing mistake
Dear Dr. Don,
A recent column said that a $250,000 annuity would generate a monthly payment of $2,268, which would be a return of 1.7 percent. However, I calculate that $2,268 monthly would be $27,216 per year, which is an annual return of 10.8 percent. What gives?
-- Jon Justify
You're confusing the return of principal with the yield on the investment. It's a common investor mistake, which is why I chose to answer your good question. Getting your money back is an important part of investing, but don't confuse it with yield. Upon review, my numbers were correct in the column you are referencing.
There are several types of investments where the cash flow to the investor includes the return of capital. Aside from immediate fixed annuities, master limited partnerships and real estate investment trusts are two examples of investments that may return investor capital over time. Total return on the investment is the yardstick for investors in these investments, not the distribution rate.
Because the initial questioner was interested in a term certain annuity, it was easier for me to calculate the yield in a spreadsheet. If it had been a lifetime annuity, the yield calculation is based on the annuitant's life expectancy. But the realized yield would vary based on the date of the annuitant's death and any beneficiary options priced into the annuity.
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