When to Annuitize?
Mortality credits are what make annuities worthwhile to consider. Offsetting the mortality credits are the costs embedded in the insurance contracts—costs that include not only management and administrative expenses, but distribution expenses (such as marketing costs and commissions) and the expected profit margin built into the products as well.
When we are young, the mortality credits are very small and are swamped by the costs. Thus, it doesn’t make sense to purchase an annuity when you are young. However, as we age, the mortality credits grow, eventually reaching a point where the product is worth considering. Which raises a new question: When is the right time to annuitize?
In general, the research indicates it is preferable to delay annuitization until your mid-70s or even your early 80s. A 2001 study, “Optimal Annuitization Policies: Analysis of the Options” by Moshe Milevsky, concluded that a 65-year-old female has an 85% chance of being able to beat the rate of return from a life annuity until age 80. For males, the figure was 80%. (Keep in mind that insurance companies issuing these policies are aware they are being adversely selected. The most likely buyers of longevity insurance are those who have a good reason to believe they will live a longer-than-average life.)
Another consideration is that in today’s environment of very low interest rates, the purchase of an annuity is locking in these low rates. (One strategy, then, is to diversify that risk by building a ladder of annuities over time, buying an equal amount over a period of, say, five or 10 years.)
Of course, delaying the purchase runs the risk rates will fall further. However, each year of delay also earns you more mortality credits. If you delay long enough, the mortality credits can even exceed the equity risk premium.
The bottom line is that, given today’s interest rates, and unless you are highly risk averse, you should probably not buy an immediate fixed annuity until your mid-70s or even approaching age 80. Similarly, if you are considering buying a deferred fixed annuity, you should think about delaying payments until age 80. There is one caveat, however, that goes with this advice.
Delaying the purchase of an annuity runs the risk that life expectancy increases, in turn increasing the cost of the annuity. A 2006 study, “Rational Decumulation” by David F. Babbel and Craig B. Merrill (both of the Wharton School of the University of Pennsylvania), calculated that a 1% annual improvement in mortality is associated with roughly a 5% increase in the price of an annuity, or a 5% reduction in monthly payouts. There’s also the risk that interest rates will fall from even today’s low levels, leading to lower monthly payouts upon annuitizing.
Which Annuity to Choose?
As mentioned, when deciding on a payout annuity, there are two types to consider, either an immediate or a deferred annuity. My recommendation is that, unless you already are approaching age 80, you should strongly favor the purchase of a deferred, or longevity, annuity. The reason is straightforward: We buy insurance to cover risks too dangerous for us to accept. We don’t buy insurance to protect against risks we can manage on our own.
For example, when buying automobile or homeowners insurance, it is usually the best strategy to buy the policy with the highest acceptable deductible that is appropriate in terms of risk. That limits the cost of the insurance.
Consider an investor who is 65 and has accumulated a portfolio that provides very high odds of not running out of money for the next 15 years. Thus, the main concern for our investor should be regarding the “risk” of living longer than 15 years. There is no need for an immediate payout annuity.
