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.
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%.
Developing A Retirement Plan
Equity investors must also consider that market volatility calls into question the use of risky assets to generate stable periodic cash flows throughout a long-term horizon. The reason is that, although long-term expected returns from stocks may be attractive, a sequence of negative returns can deplete a retirement income portfolio to the point where it lacks sufficient dollars to recover. In other words, the sequence of returns matters.
Consider the following example: From 1973 through 1999, the S&P 500 returned 13.9% per year and inflation rose 5.2% a year. Thus, the real return for an investor in the S&P 500 Index was 8.7%. Knowing this, in hindsight, one might think you could retire in 1972 and still safely withdraw an inflation-adjusted 7% every year (almost 2% per year below the annualized realized return) from your original principal and not worry about running out of assets.
However, because the S&P 500 declined by approximately 40% in the 1973-1974 bear market, the portfolio would have been depleted by the end of 1982—in just 10 years! In the decumulation phase, certainly the order of returns matters a great deal.
The bottom line is that success in retirement planning requires the careful consideration of your ability, willingness and need to take risk; appropriate and forward-looking assumptions about expected returns; an understanding of the consequences of changes in wealth; spending requirements; assessment of alternative strategies; and once the plan is implemented, ongoing monitoring not only of the financial condition of your portfolio but the spending assumptions made in building the plan as well.
When developing a retirement plan, your first objective should be to ensure the sustainability of adequate income over a lifetime. Risk modeling tools, such as a Monte Carlo simulator, play an important role in helping to determine the likelihood of ending with positive wealth, and if there is a shortfall, what its magnitude and duration may be. And risk models demonstrate that payout annuities can play an important role in retirement planning, helping to reduce the risk of running out of assets.
The Annuity Puzzle
Numerous academic studies advocate partial to full annuitization of financial assets. Despite the evidence, the majority of investors remain reluctant to annuitize both for behavioral and financial reasons.
Why or Why Not Annuitize?
An annuity is not an investment vehicle. Instead, it’s an insurance product designed to protect an individual from a catastrophic risk, specifically the risk of running out of money in retirement. It allows an individual to convert a lump-sum payment into a stream of income that continues for life.
The future payments from the annuity protect an individual from both financial market risk and, more importantly, longevity risk. Because the risk of outliving one’s assets is reduced, and annuities have built-in mortality credits, the academic literature has found structured annuity payouts allow a retiree either to increase the amount of dollars they can expect to withdraw from a portfolio without increasing the odds of failure (depleting assets) or to maintain the same withdrawal rate while increasing the odds of success.
The concept of a mortality credit is illustrated by the following example. On Jan. 1, we have 50 85-year-old males who each agree to contribute $100 to a pool of investments earning 5%. They further agree to split the total pool equally among those who are still alive at the end of the year.
Also, suppose that we (but not they) know for certain that five of the 50 will pass away by Dec. 31. This means the full pool, now $5,250 ($5,000 principal plus $250 interest), will be split among just 45 people. Each will receive $116.67, or a return on investment of 16.67%. If, instead, each person had invested independently of the pool, the total amount of money earned would have been $105, or a return on investment of 5%. The difference in returns is the mortality credit.
Despite the mortality credits, most individuals still hesitate when it comes to annuities. One reason is behavioral. A lot of investors exhibit what is called “loss aversion.” They feel that converting to an annuity “gambles away” their assets should they die earlier than expected. Thus, their heirs would inherit a smaller estate. Another reason is that some investors dislike giving up control of their assets, believing they might do better if the money remained and grew in their own investment accounts.
In addition, investors can be deterred by financial restrictions. Since most annuities are illiquid and irreversible, assets cannot be accessed should unexpected needs, such as health-related costs, arise. As a result, they may impose an unacceptable constraint on future consumption.
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.
By purchasing the deferred annuity, you are buying the insurance only for the period for which it is needed, the mortality credits are much greater, and you greatly reduce the liquidity constraints imposed by the purchase of an immediate annuity. The later the start date, the lower the upfront payment will be. For example, one study found that for the same spending benefit, an individual purchasing an immediate annuity would have to annuitize more than 60% of his/her retirement assets versus just 11% of assets with a longevity annuity.
The same study ran additional scenarios comparing the spending benefits between men and women to highlight the difference in mortality rates by gender, and to further illustrate the higher spending benefit of longevity annuities over the purchase of immediate annuities. The results are shown here:
Partial annuitization through the use of longevity insurance not only reduces the risk that an individual will outlive their assets, but maintains the majority of assets in liquid, investable and, if possible, tax-managed accounts for flexibility and potential growth. This strategy is ideal for risk-averse investors with significant concerns about the possibility of outliving their assets.
Immediate annuities can be purchased using tax-deferred dollars because the annuities satisfy required minimum distribution (RMD) rules. In July of 2014, the Treasury department issued new regulations surrounding the purchase of deferred-income annuities in tax-deferred accounts.
The new regulations allow for the purchase of deferred-income annuities in qualified retirement accounts that begin payments after age 70.5 without violating RMD rules. However, there are certain requirements the qualified annuity must meet in order for the IRS to allow for annuitization after age 70.5:
- Only 25% of any retirement account (or 25% of all pre-tax IRAs aggregated together) can be invested into a deferred income annuity.
- The cumulative dollar amount invested in all deferred-income annuities across all retirement accounts may not exceed the lesser of $125,000 or the 25% threshold. The $125,000 amount will be indexed for inflation, adjusted in $10,000 increments.
- The limitations will apply separately for both spouses with their own retirement accounts.
- The deferred-income annuity must begin its payouts by age 85 (or earlier).
Finally, the guaranteed income generated by the longevity annuity can allow a retiree to be more tolerant of risk, thereby making it more likely that they’ll stick to a specific investment strategy during the inevitable bear markets. In addition, a retiree might feel more at ease to spend a greater portion of savings earlier in retirement, knowing that the longevity annuity payments will kick in at a later date.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.