Swedroe: Annuities & Problems Of Longevity

April 11, 2016

As the director of research for The BAM Alliance, I frequently receive questions related to the advisability of purchasing payout annuities (as opposed to variable annuities, which I generally categorize as products meant to be sold, not bought).

Combine the relatively poor performance of equities since 2000 (the S&P 500 returned just a little more than 4% and the MSCI EAFE index returned less than 3%) and the fact that current bond yields are at exceptionally low levels with concerns about Social Security’s solvency and the demise of defined benefit plans (then add in longer life expectancy), and it’s no wonder investors are seeking alternative strategies to ensure they’ll have sufficient assets to support their desired lifestyle in retirement. Given the importance of this issue, and how often I’m asked about it, I thought I would share my thoughts.

To begin, we buy insurance to protect our homes, cars and lives, transferring some or all of risks we prefer not to bear ourselves. Thus, buying insurance is really about diversifying risks we find unacceptable, because the costs of not being insured and having the risks “show up” are too great. The same logic applies to the purchase of payout annuities, payments from which can be in either nominal or inflation-adjusted (at least to some degree) dollars.

At its most basic level, deciding to purchase a payout annuity is a decision to insure against longevity risk (the economic consequences of outliving a portfolio of financial assets meant to provide lifetime income). As the pain of outliving one’s financial assets is extremely high, purchasing a payout annuity makes sense for individuals running significant risk of this event occurring. Hopefully, the following analysis will supply you with the necessary information, and proper framework, to analyze the problem.

Longevity Risk

The average remaining life expectancy for people surviving to age 65 is now about 13/15 years for the male/female 1940 cohort, and about 15/20 years for the male/female 1990 cohort. These, however, are just averages.

When thinking about longevity risk, you should also consider that, today, a healthy male (female) at age 65 has a 50% chance of living beyond the age of 85 (88) and a 25% chance of living beyond the age of 92 (94).

For a healthy couple, both 65, there is a 50% chance one will live beyond the age of 92 and a 25% chance one will live beyond the age of 97. This means that, assuming an investor is in his or her mid-60s, an investment portfolio may have a planning horizon greater than 35 years.

The risks of longevity have become greater, especially within the blue-collar group. It’s been well-documented that, in this group, we have an emerging retirement crisis due to the decline of defined benefit pension plans, a discomfort with investing in higher-expected-return assets (an issue related to financial illiteracy), and stagnation in real wage growth (leading to difficulty in accumulating preretirement wealth).

Exacerbating the problem is the low-yield environment we’ve been living in since 2008, making it more difficult for traditional fixed-income-oriented strategies to provide adequate and sustainable income that meets the desire to maintain established lifestyles.

In addition, at least in the United States, equity valuations are higher now than historically has been the case, leading financial economists to forecast equity returns of roughly 6-7% versus the historical figure of about 10%.

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