Annuity/Pension vs. Lump-Sum- Part 2: Drivers to and away from annuitization

In a nutshell

In Part 2 of this series of five blog posts, we approach the annuity/pension vs. lump-sum decision qualitatively to allow individuals to tentatively screen themselves into an annuity or lump-sum direction; in follow-on blog posts we explore quantitatively the decision to annuitize, when it might make sense to do so and how the outcomes compare to a systematic withdrawal strategy. The “when to annuitize?” question is also addressed. The mindset is that since annuitization is insurance and you only buy insurance if/when you need it, then staying the course we’re on (wherever that might be, annuity/pension or investments) due to “fear of regret” that a proactive choice might lead to a worse outcome than not choosing at all, is not necessarily the optimal decision.

This five part series on Annuity/Pension vs. Lump-Sum is composed of: Annuity/Pension vs. Lump-Sum- Part 1: Making the right decision for you which explores risks in retirement,  Annuity/Pension vs. Lump-Sum- Part 2: Drivers to and away from annuitization  focused on qualitative considerations toward the annuity/pension vs. lump-sum decision,  Annuity/Pension vs. Lump-Sum- Part 3: Quantitative considerations focused on quantitative considerations in the decision,  Annuity/Pension vs. Lump-Sum- Part 4: Monte Carlo simulation to explore retirement income trade-offs with and without annuitization where Monte Carlo simulation is used to explore the range potential outcomes given assumed Capital Market Expectations, (risk tolerance and corresponding) Asset Allocation, in the context of personal circumstances (Age, Assets, Expenses, Other Lifetime Income sources and the resulting required withdrawal rate) and compare these with annuitization. Then in order to help see the entire picture, in the 5th and final part of this series  Annuity/Pension vs. Lump-sum- Part 5: Putting it all together  I use the case of an 85 year old single male with a life expectancy (i.e. 50th percentile) of the order of 5 years and a 90th percentile life expectancy of about 11 years, instead of the mostly used 67 year old couple who needed to finance a potentially 30 year long retirement.

Disclosure and warning

Note that none of what follows should be construed as advice on what you personally should do in your Pension/Annuity vs. Lump-sum decision. Think of this as my (Peter’s) journey to such a decision (which it is) and feel free to consider this as only educational material on how one might go about examining such a decision in as informed manner as possible. There is no one universally right answer; what may be right for me might be completely wrong for you (and I haven’t even made my decision). The future is unknown and unknowable (as most of us found out in the fall/winter of 2008/9) and the lack of transparency of financial products in general and insurance products (like annuities) in particular, make the annuity vs. lump sum decision particularly difficult. Furthermore, limitations (cloudy crystal ball) of capital market expectations, models, assumptions, simulation approaches which are used to explore possible outcomes, will almost certainly insure that the future will not unfold as expected.  Unbiased professional advice (ideally with a fiduciary level of care) on such important decision is usually advisable. This further complicates matters because of potential conflicts of interest which burden many of those that you might approach for advice (from insurance salespersons who would benefit from selling you an annuity, all the way to advisors under pressure to accumulate assets under management (AUM) from which they generate fees. So keeping in mind that I am not an actuary, that there is potential for errors on my part, and that your personal circumstances/perspectives may be radically different than mine though ultimately the primary drivers to the decision.


In Part 1 of this series of blogs, we looked at the key risks in retirement: longevity risk, inflation risk and market risk, and how an annuity is trading-off longevity risk for inflation risk. We also discussed the implications of the annuity being insurance rather than an investment, and that it brings with it some new risks such as: credit risk, liquidity risk and no estate value.

Here in Part 2, we’ll focus on qualitative considerations which drive us to or away from annuities, before we move in Part 3 to look at quantitative considerations in the annuitization decision: starting with fixed and discretionary expenses, capital market expectations, how/when/if to annuitize, understanding the value of an annuity in terms of the implied IRR (internal Rate of Return) as a function of longevity, and alternatives to annuitization like: self-annuitization and systematic withdrawal strategies, using NPV to compare decumulation strategies, bracketing the portfolio risk using minimum return requirement (minimum risk level required) and portfolio stress testing (maximum risk level tolerable) and we close with annuitization triggers. But first we’ll consider the qualitative drivers.

Pension/Annuity or Lump-Sum? Most stay the course due to “Fear of regret”

Pension/annuity (which are used as synonyms) vs. cash-value (commuted-value, lump-sum also used as synonyms) as we approach retirement (or in retirement if option is presented again) is not an easy decision. In fact it seems that most people don’t actually make a decision at all; they just continue on the path of least resistance, the path they are already on.

Those people who still have a DB pension (especially the inflation adjusted and government guaranteed kind) tend to just stay with the pension (even though typically upon retirement they have the option to take the equivalent cash-value of the pension), while those who are members of DC-type plans hardly ever elect to buy an annuity with some or all of their retirement assets.

Many suspect behavioural finance scientists would argue that people continue along the path that they are already on because of “fear of regret” in case their proactive choice to change direction would, in retrospect, turn out to have been worse than staying the course.

Qualitative consideration driving one toward an annuity

There are a whole set of qualitative consideration which we could use to explore whether we are better suited for annuitization; the more of these we answer as being True (rather than False), the more likely that an annuity (an insurance) is more appropriate for us, than a systematic withdrawal plan (an investment).

Figure 1-Qualitative factors driving toward annuity/pension

Factors which might drive one toward the pension/annuity rather than lump-sum would be, if you:

-have no desire to leave an estate

-are not a Do-It-Yourself (DIY) investor and haven’t managed and/or can’t manage your own investments

-don’t have a capable/reliable adviser/individual whom you trust to manage your investments and is prepared to do it on a fiduciary level of care

-are very conservative investor- in the past mostly in cash, GICs/CDs and bonds

– expect to live well past life expectancy for your age, because your health is good and have a family history of longevity

-have no other source of lifetime income beyond OAS/CPP or Social Security (i.e. no other pension)

-have other adequate assets for reserves/emergencies

– sold all or a significant portion of your stock holdings (if you held stocks) during/after the 2008-2009 crash

-don’t want to lose sleep over stock market dropping, or how to draw income from your investments, or whether your assets will last your lifetime

-are not worried about the insurance company or employer failing to meet it lifetime annuity or pension income promise

-your pension plan is fully funded and your employer is in good financial health

-prefer a  fixed (nominal) but guaranteed income even if it reduces or eliminates your flexibility/liquidity

-prefer a constant income which erodes in value with inflation and leaves no residual assets, as opposed to a variable, but possibly increasing, income with potential for some residual assets

– could manage financially even as inflation might erode 30-50% of the buying power of your annuity/pension

-must annuitize all assets or need your entire pension to cover your expenses

-have no dependents who are relying on your pension/annuity and who would suffer should the pension stop or be reduced significantly if you died first

Figure 2- Qualitative factors driving away from annuity/pension

Driving you away from pension/annuity toward a lump-sum would be if your situation was the opposite the statements in Figure 1 above, for example if you:

-already have other sources of lifetime income (OAS/CPP or Social Security, and other pensions/annuities especially if inflation indexed) which fully/mostly meet you annual income needs now and so long as you live (including the corrosive effect of inflation)

-your health worse than the average for your age, and you have a family history of not living to a ripe old age

– can manage your own investments or have a reliable/capable and trustworthy adviser on whom you can count on managing assets at a reasonable expense level and at a fiduciary level of care

– have invested in balanced portfolios (say 50% stocks) in the past

-can absorb a 50% stock market drop (i.e. a 25% drop in portfolio value for a 50/50 allocation of stocks/fixed-income) with your chosen asset allocation without requiring dramatic lifestyle change

-want to leave an estate

-want to preserve the liquidity/control that comes with not annuitizing

-have dependents counting on the ongoing income stream and would suffer if that would stop or decrease (as might be the case if your pension/annuity had no or reduced survivor benefits)

-can deal with some income variability in exchange for opportunity to mitigate inflation and preserve assets for major expenses and/or estate

-have other assets so the pension/annuity income is not all needed to meet expenses

-your pension fund is not fully funded and your employer is not financially strong

-your assets are in a taxable account (potential tax benefits since annuity payouts are all taxed at income rates)

When to annuitize?

You can find experts arguing: from “you should never annuitize” all the way to “don’t wait to annuitize”. There are also some who argue that one should annuitize in stages to minimize interest rate risk, while others arguing that one should annuitize as late as possible. The latter argue that since annuities come with mortality credits, and the mortality credits increase with age, you would like to tap into these mortality credits only when they are significant or at least exceed the built in costs of the annuity (probably somewhere around ages 75-80). These mortality credits result from some annuitants dying each year and their assets and their returns being available to be shared among those still living in the annuitant pool; the mortality credits are just about the only way to boost ‘returns’ beyond those available from the market. These arguments for later annuitization are based on the existence of frictional costs in the real world and where at some younger ages during retirement the net gain of annuitization (mortality credits minus frictional costs) might even be negative. Even those who expect to need a (delayed) annuitization might consider skipping the traditional (SPIA) annuity altogether and buying instead a (pure) longevity insurance (available in the US, but not available in Canada) which is also bought for a single premium around age 65 to secure a lifetime income but typically only commencing at age 85. Yet others suggest allocating a reserve for buying an annuity at age 85, but not pulling the trigger until then, and even then only if necessary.

So far what we have been discussing is “when to annuitize?” given that we have an intention to annuitize at some point. However, as with any insurance (typically though not always, insurance is not just not free but not even cheap), it should be bought by those who need it, and when they need it. Of course, the ultimate delayed annuity is the one that ends up not being necessary at all (e.g. the person died before pulling annuitization trigger or person has sufficient assets not requiring annuitization) and therefore never bought.

Comparing Annuity (insurance) vs. other decumulation strategies (investments)

If you haven’t as yet made a decision to annuitize purely on the qualitative drivers above, in Part 3 we’ll start looking at quantitative considerations, the first of which will be to get a good understanding of your expenses in detail (actually you might even need this to do the qualitative considerations)

Also, you often hear comments suggesting that annuities have much better ‘returns’ than CDs/GICs or bonds today. But that’s not even comparing apples and oranges, but more like comparing apples and donkeys (since at least oranges are fruit). Bonds and CDs/GICs, while not the same either, at least the invested capital in both cases is (hopefully) returned on maturity and income they throw off is of the same nature, interest. An annuity (SPIA) on the other hand is an insurance product where the premium is essentially equal to the capital you annuitize, so if you die shortly after the purchase (of a zero guaranteed period annuity) you essentially have forgone your capital; on the other hand, the insurance company guarantees the promised income for as long as you live. But the way to think of the income from an annuity is as being comprised of interest (like from bonds), return of capital/premium (your own money) and mortality credits which result from capital/premium left behind in the annuity pool by those who died earlier than expected (e.g. see All income is not alike).

The decision to stay with a pension or commit to buying an annuity with (some or all of) one’s accumulated retirement assets is a decision to buy an insurance product, even though it is often framed as an investment decision. Trying to compare an investment and an insurance product is a non-trivial exercise; given the same amount of assets being considered for investment or insurance premium, then we need to evaluate the cash flow that might be generated via a systematic withdrawal from the original investment plus interest/dividends/capital-gains, and compare with the very simple lifetime annuity income stream. Some of the difficulties include that: one doesn’t know how long one is going to live, what are alternative investments consistent with decision maker’s risk tolerance, how to compare them against annuities, the impact of locking-in the current intermediate/long term government bond rates (about 2.5% at this writing) when buying an annuity, and the corrosive effect of the unknown future inflation on the buying power of the fixed income stream over a 20-35 year retirement.

Bottom line

Qualitative factors were explored to better understand the suitability of annuities (insurance) vs. other decumulation options (investments) so that we can gradually evolve toward fact rather than fear based decision.

The qualitative factors based decision using the statements in Figure 1 and Figure 2 above broadly lead to the following conclusions:

-if you have no desire to leave an estate, have better than average health from your age group, you are an ultra-conservative investor, you understand that an annuity is trading-off longevity risk for inflation risk, you understand that an annuity is insurance not investment, you are not worried about the financial health of your employer or insurance company’s ability to deliver on its annuity promise and/or other factors mentioned, then you might be leaning to an annuity/pension

-if you have a desire to leave an estate, you are a do-it-yourself investor, have average or higher risk tolerance with a history of investing in equities, or have average or lower than average for your age state of health, or your pension plan is underfunded and are worried about your employer’s financial health or about insurance company meeting its annuity promises, or want to preserve liquidity and control over your assets, then you might be leaning away from an annuity/pension

If you in the latter group of those leaning away from annuities/pensions based on qualitative factors and you don’t want to make a status quo decision based on “fear of regret”, then you are ready to explore some quantitative considerations in the annuity/pension vs. lump-sum decision in Part 3.


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