Scott, Watson and Hu in their Pension Research Council paper “Efficient Annuitization: Optimal Strategies for Hedging Mortality Risk” prove what readers of this website have heard from me many times before (though expressed only subjectively or supported by tentative empirical observation), that longevity insurance (what the authors call delayed payout annuity) is the most advantageous implementation of annuitization. (Note that delayed payout annuities differ from deferred annuities in that deferred annuities tend to be primarily a tax deferral mechanism with an option to cash in accumulated assets, with perhaps a penalty, prior to start of annuity payouts, whereas delayed payout annuities are irreversible).

The authors show that just 6% of one’s wealth allocated to a delayed payout annuity would be required, to achieve the same impact as 39% of one’s wealth allocation to an immediate annuity. They do this by measuring the efficiency of an annuity, where efficiency is defined as “providing the most expected utility”.

 

Annuities are categorized as: (1) immediate annuities, (2) delayed purchase annuities (they show that these are more efficient than immediate annuities, even disregarding the equity risk premiums available for unannuitized assets), and (3) delayed payout annuities (these are proven to be the most efficient implementation since annuitized income consumption only starts late in life).

 

In fact the authors also prove that under reasonable assumptions, it is “never optimal for annuitized payouts to precede non-annuitized portfolio payouts”; i.e. delay payout annuity, or longevity insurance, is optimal mechanism for dealing with longevity risk. The delayed payout annuity, requiring the much smaller proportion of wealth to be annuitized, resolves most of the disadvantages/objections articulated in earlier papers associated with immediate annuitization, such as: liquidity, bequest motive and potentially undesirable asset allocation.

 

The bottom line of their analysis is that, even under circumstances of unfair actuarial pricing of annuities and in the presence of already annuitized assets (social security or company pensions), the irreversible deferred annuities or delayed payout annuities are the most efficient use of the annuitized dollars.

 

An interesting example is an offering by MetLife called Longevity Income Guarantee (LIG)  (this is not a product endorsement) comes in two versions, where a $50,000 premium at age 55 results in: (1) Flexible Access Version, income can be taken anytime the need start after a two-year waiting period and annual payout about $15,000 and $50,000 if taken at ages 75 and 85 respectively, or (2) Maximum Income Version where income start at age 85 at about $72,000; all this is constantly changing with available rates. The Maximum Income Version would appear to be the delayed payout annuity based on this press release (though I haven’t read the product description). (Note added March 12, 2012: MetLife longevity insurance product is also mention in Kiplinger in 2007; unfortunately with interest rates now moch lower than in 2007 the income streams have also dropped.)