Annuities II: (Almost) Everything you wanted to know about annuities, but were afraid to ask

In the Annuities I blog we discussed “what is (the measure of) wealth? Here we’ll discuss what annuities are, what flavours they come in and what are some their pros and cons. (Annuities III  and  Annuities IV are the remaining two blogs in this series of four on annuities, that you might find of interest; there are also some additional related blogs discussing the lump sum vs. annuity decision.) In Life-Cycle Investing model we discussed how during one’s life, one needs to consider various risks and protection mechanisms to one’s Human Capital and Financial Capital as part of the total plan:
(i) disability: disability insurance (HC) (ii) death: life insurance (HC) (iii) market/investment: diversification/asset-allocation (including futures and options), hedging (including options), single vs. multi-period investment horizon (i.e. in the long-run you appear to be OK, but on the way, while withdrawing funds annually during a succession of negative returns, you may become insolvent), cap investment in employer (FC) (iv) longevity: DB plans, (delayed) SS/CPP, immediate or deferred annuities (especially if inflation indexed), estate/bequest plan (FC) (v) inflation: inflation indexed bonds, inflation indexed annuities (FC)
In retirement one is particularly concerned with the last three of these risks and annuities can play a role in mitigating all three: (iii) annuitization can eliminate/reduce investment risk (at the expense of elimination/reduction of the residual estate), (iv) longevity risk (lifetime annuity income) and (v) inflation risk (inflation indexed annuity).

Of course one must remember that annuities are an insurance product and as such they introduce new problems: higher costs (e.g. insurance is not free) and counterparty risk (e.g. will the insurance company must be solvent when the claim must be paid).

For a 65 year old individual the gender independent life expectancy is about age 82; so half the 65 year olds will live until less than, and the other half till more than age 82, respectively. For a 65 year old couple there is an over 25% probability one of them living past age 95 (Ibbotson, Milevsky, Chen and Zhu). Annuities are a form of longevity insurance, whereby typically for single premium paid, an insurance company promises to pay a lifelong income stream with no residual value at death. So you trade part or all of your assets for a lifetime income. (A guaranteed payment period option is often available at extra cost). The annuity can start immediately after the single payment is made by the annuitant (called an SPIA- Single Payment Immediate Annuity) or it may start many years later (called an SPDA- Single Payment Deferred Annuity).

The return that one obtains from an annuity (after expenses) comes a result of number of sources: (1) the usual investments return on the payment made to the insurance company, (2) tax deferred growth in the annuity and then tax advantaged income from the annuity (part capital and part return on capital) and (3) mortality credits.

To explain mortality credits consider Milevsky’s “Grandma’s Longevity Insurance” interesting paper about a group of 95 year old grandmothers’ tontine to explain how annuities work. Essentially the return each year is part interest, part capital (this also has tax advantages) and part the assets contributed by those who have died. Since the insurance company’s pool of policyholders has a finite life expectancy upon which payments were calculated, there is no residual return to the policyholder after death. Those who die early in effect pay for those who live past the life expectancy. He even calculates the value of mortality credits (i.e. what you must earn above pricing rate to justify not annuitizing) at different ages of annuitization. In his specific example the mortality credits at ages 55, 65, 75, 85 and 95 are 35, 83, 237, 725 and 2004. So you see why many will recommend that you should delay annuitizing to at least age 75.

Peter Katt in “The Good, Bad and Ugly of Annuities” has a good overview of annuities. I’ll try to summarize here:

-Deferred Annuities (DA) and Immediate Annuities (IA)- in deferred value accumulates on tax-deferred basis; guaranteed payment periods are available for both -Fixed annuities (FA) typically deliver current market interest rates for some guaranteed period (e.g. 5 years) when the rate is reset to the then prevailing rates. Fixed annuities are guaranteed to have no losses. Variable annuities (VA) allow annuitant to choose from various types of subaccount such as stock, bond, etc. Fixed and variable annuities can be immediate or deferred. -Equity index annuities (EIA) promise a capped participation on equity returns, since just like FA in that there is a guarantee of no losses.

Some of Katt’s generic recommendations are that:

1. DAs are preferred (except for investors with large estates), 2. VAs are unsuitable for most investors (except traders) as they convert capital gains to income, 3. EIAs are less attractive than fixed annuities.

The decision to annuitize, how much or not at all, is a function of many factors including: individual’s age, health, family history of longevity, risk tolerance and relative desire to consume as opposed to leave an estate according to Ibbotson,Milevsky, Chen and Zhu (if the bequest motive is very high one can purchase life insurance). Once you have made a decision to annuitize, in addition to deciding when, you must decide how much of the assets to annuitize. Furthermore some recommend that you do not annuitize the entire target amount at one time, but rather according to Ibbotson et al “a body of literature is emerging that suggests that investors should annuitize slowly, as in a dollar-cost-averaging (DCA) strategy. Depending on contract and policy features, this process would start at, for example, age 65–70 and continue until age 80 or 85, until the entire amount of desired annuity income was actually annuitized”.
Despite the advantages of annuities, relatively few retirees actually include them into their portfolios. This is called the “annuity puzzle; some of the explanations offered by Horneff, Maurer, Mitchell and Dus, to explain the lack of interest in annuities are: loss of liquidity while alive, bequest motive, “high insurance company loadings, ability to pool longevity risk within families, asymmetric mortality expectations between annuity buyers and sellers and the existence of other annuitized resources”. Also one must consider the counterparty risk; i.e. that since annuities can span 20-40+ years, the insurance company promising to make the lifetime payments, must stay solvent to fulfill the promise.
An option to consider would be to buy a pure longevity insurance (no bells and whistles, like guarantees or life insurance), which is a deferred annuity (SPDA) starting at, say, age 85; this would commit a much smaller portion of an individual total capital at age 60 and payments would start at the selected age (85) and would continue until the death of the annuitant. A 60 year old male/female/joint SPDA annuitant(s) could pay a single premium of $50,000 today and start getting $50,800/$38,300/26,000 annually starting at age 85 from Berkshire Direct. Somebody with $1,000,000 assets may find this a relatively painless way of getting some longevity insurance; if they die young they won’t miss the 5% of their asset paid for the premium, while if they live well past 85 they get some protection.

Next week’s blog, I’ll take some specific examples of portfolios with immediate and deferred annuities as well as no annuities, and we’ll try to assess the wealth of the investor as defined in Annuities I as achieving a desired spend rate (with a defined withdrawal strategy) over some horizon, resulting in a (1) probability of success (essentially not running out of money) and (2) residual net-assets.