Annuities And Retirement Income
This is a short and generic introduction to annuity contracts for people who are exploring ways to generate retirement income and hedge the risk of outliving their money.
You may have a passing familiarity with the insurance product called a life annuity, which promises to pay a guaranteed income for the remaining life of the beneficiary (often, you are the beneficiary).
The life annuity has been around since the Middle Ages when merchants traded personal wealth with local monasteries in exchange for the promise of lifetime support and protection for their families within the monastery. But, as the legends go, many monasteries later found themselves in financial crisis because they failed to collect sufficient wealth to fund these long-term obligations. Despite this, annuities persisted.
The wide variety of annuity contracts and policy riders available makes it hard to give you universally accurate statements about annuities. So, what I’ll do is describe annuity basics and if you’re keen to learn more, you’ll want to find a credible insurance advisor that you trust.
The Basics Of Annuities
An annuity is a contract in which an insurance company promises to make a series of periodic payments (usually a sequence of payments lasting for life). The insurance company does this in exchange for either a large single premium collected at the beginning (called an ‘immediate annuity’) or a series of smaller premiums collected before the start of the annuity’s initial payment date.
The purchase of an immediate annuity involves an ‘irrevocable’ payment (called the premium) to the insurance company. As the purchaser, you trade that sum of money for an ‘actuarially equivalent’ income stream. Conceptually, you’re handing over a sum of money in exchange for regular income payments to you for the term of your annuity. In a way, it’s like building your own guaranteed personal pension.
The insurance company invests your premium to generate a return sufficient to cover its obligation of paying you your income and to earn a profit. Unless there is a special feature or provision in the annuity contract, the income payments stop when you die and the insurance company’s obligations end.
‘Pooled Risk And The ‘Mortality Credit’
This basic annuity structure sometimes creates misconceptions. Many describe annuities as giving your money to an insurance company that just turns around and invests in the same stocks and bonds in which you could invest. They go on to say that because all payments end at death, if you die young, the insurance company gets a windfall since you forfeit your lump-sum premium. At the core, this is true, but it misses the point of the product, which is based on the concept of ‘risk pooling’.
Consider this example. Assume that 11 80-year-old investors each contribute $1,000 at the beginning of the year so they can collectively purchase an $11,000 bond that matures in one year and pays a simple rate of interest of 3%. Each investor expects to receive $1,000 in principal plus $30 in interest one year from today, for a total of $1,030. This calculation assumes that each member of the pool receives a pro-rata return from the bond with a total maturity value of $11,330.
Now, suppose the 11 investors decide that if any one of them dies before the maturity date, the deceased investor’s ‘share’ will be distributed to the remaining living members. If one member of this group dies, the remaining members divide the $11,330 bond maturity proceeds into 10 shares, each of which is worth $1,133 (instead of $1,030).
By pooling risk, the survivors have reaped what’s called a ‘mortality credit’ (I know, morbid term) of $103, an extra return of 10.3%. The deceased pool members forfeit their shares to the surviving members, not to the issuer of the bond.
An insurance company guarantees the annuity payout for each contract regardless of which annuitants, or how many annuitants, survive the requisite period. It can do so because of ‘annuity-pricing principles’. The insurance company sets its payouts to be good enough to incentivize you to pay the premium to buy the annuity. And the insurance company is sufficiently conservative to reserve a slice of the expected mortality credits for its own profits.
The Single Premium Immediate Annuity
The single premium immediate annuity (SPIA) is a contract that begins periodic payments shortly after collection of the initial lump-sum premium payment, usually within 30 days. The attraction of an SPIA is the ability to lock in a lifetime income payment stream, which can be on an inflation-adjusted basis.
This type of transaction represents an exchange of risk, not an elimination of risk. That is, the annuity purchaser voluntarily assumes counterparty risk, which is the risk that the insurance company will be unable to honor its payment obligations.
Although there are many ways to use SPIA contracts to generate retirement income, most are variations of using the product to secure a base level of income.
In this case, the investor determines the minimum income required to cover expenses during their lifespan. This threshold may be less than the aspirational amount of income that the investor hopes to have available to spend. Nevertheless, the idea of locking in a threshold income amount at the start of retirement may appeal to some people.
If the annuity contract is reasonably priced, the annuity’s risk pooling and mortality credits could make the lifetime income more attractive than the income stream available from government-guaranteed bond portfolios.
Strategies
The investor could use the remaining money after purchasing the annuity to invest in a riskier portfolio with the expectation of generating growth in the form of income and capital gains.
The investor could delay purchasing an annuity in hopes that traditional stock and bond investments will generate returns equal to or greater than those required to generate desired retirement income.
However, should the portfolio encounter a bear market of sufficient severity, the investor can exercise the option to ‘annuitize’. The option to annuitize at an older age may make it cheaper to purchase the annuity, assuming that interest rates are favorable at the time the option is exercised.
It is cheaper to buy a lifetime income of the same amount of money at age 75 than at age 65, all else being equal. Generally speaking, the only investors who find SPIA contracts of interest are those who consider themselves to be in good health and likely to live a long life. If the investor does not expect to enjoy a long lifespan, longevity risk is a less important factor in lifetime income planning.
A few insurance companies ‘write’ SPIA contracts with high lifetime payouts for people in poor health. Actuaries call these contracts ‘substandard annuities’. When such annuities are customized to compensate people with a court-awarded payment for life-impairing injuries, they are known as structured settlements. Structured settlements may also be available to people in good health who have won a lawsuit or lottery.
‘The Annuity Puzzle’
Although the concept of guaranteed lifetime income is attractive, many investors never exercise the option to buy an annuity.
Given the annuity’s pricing advantages relative to more traditional bond investments, economists refer to the lack of widespread ownership of annuity products as the “annuity puzzle.”
Theory dictates that annuities should be popular, but reality says otherwise. Many reasons have been put forward to explain why annuities are not more widely used:
Distrust of insurance companies and insurance sales representatives
Existence of a threshold inflation-adjusted income stream provided by government pensions
Irrevocable loss of capital upon purchasing a lifetime annuity income stream
Importance of leaving the maximum possible inheritance to beneficiaries
Strong time preference for current consumption, rather than planning for remote contingency that income might be needed at age 99
Fear of such unexpected “liquidity shocks” as extraordinary medical expenses that would require large reserves of liquid capital
Fear of locking in a permanent budget constraint if a large portion of retirement savings is exchanged for annuitized income
Fear of losing control over wealth and discretionary spending
Clearly, the SPIA is a powerful financial product, but the downsides above are real and any purchase decision must involve careful planning and informed consideration.
Additional Considerations
During times of lackluster economic performance, interest rates tend to be low. But these are precisely the times when the insurance industry highlights how yield-starved investors can capture attractive cash flows by buying annuities.
Relative to the income in the form of interest paid by government-guaranteed bonds, an annuitized income stream seems too good to be true. However, an intelligent person also realizes that when money is paid to the insurance carrier, the carrier must invest in the same low- yield markets faced by all investors.
All else being equal, when interest rates in the general economy are low, insurance carriers do not offer the amount of lifetime income per premium dollar that they offer during periods of higher interest rates. After all, if the insurance carrier can earn only 3% on its assets in a poor economy, it cannot pay out as much as it can if its invested assets earn 6%, for example.
Yet it is during bad economies that annuities look best to those concerned with inadequate periodic income. In terms of timing, buying an annuity contract in a low-interest, recessionary economy is probably the worst time to do so, which is troubling because that’s precisely when people are seeking safety and security.
Buying an annuity is equivalent to exchanging the risks traditionally associated with portfolios of financial assets for increased interest rate sensitivity.
Conclusion
The pace of innovation in the insurance industry remains strong.
From the industry’s perspective, the challenge is to offer products with sufficiently appealing long-term guarantees to attract consumer interest while developing profitable strategies to fund the guarantees in a low-interest-rate environment.
From the consumer’s perspective, the challenge is to analyze the financial risks, rewards, and costs of implementing annuity-based solutions
