The retirement question often surrounds how much money you’re making, saving, and spending. It’s all about the time when work ends and, presumably, fun begins. You’ve either been stashing cash away, buying stocks, or even building a family business with the possible goal of selling it and enjoying retirement. Yet once retiree life begins, the financial work doesn’t suddenly end. The question now becomes: How will you make your savings last so you don’t run out of money before you run out of life?
Take Steve and his wife, Anne, who are both in their mid-50s. After retiring, the couple wants to take a cruise or two, do some humanitarian work, and make sure they have enough to afford any medical or nursing home expenses when they reach their late 80s. The problem is their Social Security money won’t cover it all, and there is a chance those benefits may decrease substantially by the time they need them. If they have $1 million saved, they could live quite comfortably for some time. But what happens if they both lived into their 90s?
When retirement arrives they may fare far better devoting a chunk of their savings to a life annuity. Life annuities can be thought of as a financial savings account where you deposit your money, and, in return, the bank guarantees you fixed monthly payments each month for the rest of your life, whether it’s ten years or twenty-five.
In essence, an annuity is the opposite of life insurance, where the payments of those who remain living go to cover the benefits paid to the estates of those who die prematurely. In the case of life annuities, the risk of outliving one’s income is pooled among all annuity purchasers, providing a kind of insurance against outliving one’s assets.
But a word of caution is in order. The life annuities, also called immediate annuities, discussed here are different than deferred annuities. Deferred annuities, also called fixed, variable, or index annuities, have an accumulation period of five to ten years or more before any payments are made to the purchaser. Deferred annuities are a very different animal than the immediate life annuities discussed here.
At a time when people are living longer and the longevity of government assistance like Social Security is being questioned, many economists agree annuities represent a strong choice to safeguard one’s lifestyle for the rest of his or her years.
The Perfect Storm
The decreasing levels of Social Security and pensions, along with the aging baby boomers and increasing longevity of Americans, has created a perfect storm—and we need to protect ourselves from its barrage.
For many workers in the past, retirement signaled a time when you would stop working and collect your company’s pension for the rest of your life. These pensions are known as defined benefit programs where the receiver knows how much he or she will be receiving each year. But their use is dropping fast. During the past fifteen years, there has been only one new pension program of any size initiated in the United States. The number of pension plans in the United States peaked at 175,000 in 1983 and has since declined to less than 25,000.
Many of those that remain are insolvent or otherwise underfunded, and the government’s Pension Benefit Guarantee Corporation, which insures them, is reeling under a load it cannot sustain. During the past fifteen years, 401(k)-style-defined contribution plans increased from around 17,000 to more than 450,000. When all defined-contribution-type plans are included, there are more than 650,000 today.
This switch from defined benefit to defined contribution plans means more financial risk will be felt by each of us. Instead of receiving a guarantee, we must make sure we are saving enough to meet our future needs. Put another way, the financial risk of retirement has been transferred from those best able to bear it to those less knowledgeable and least able to bear it.
As pensions disappear and Social Security becomes less sure, annuitization becomes an increasingly important retirement strategy.
Last year the first of the baby boomers signed up for Social Security benefits. Another 80 million are coming. Baby boomers, along with subsequent generations, will be burdened not only with the responsibility of providing for their own future retirement and health needs but also with supporting the Social Security and Medicare costs of the elderly. The net effect of this is that there will soon be many more people draining funds from the Social Security system, with far fewer people contributing to it. In 2006 there were 7.2 persons between the ages of eighteen and sixty-five for each person over sixty-five. Within the next twenty-three years, this ratio is projected to drop to 3.7, according to the Census Bureau.
If, at retirement, people plan their finances to cover their needs throughout the remainder of their expected lifetime, which is roughly until age eighty-six, half of them can be expected to fail. This is simply because half will live longer—and many much longer—than their life expectancy. A healthy couple at age sixty-five has a 50 percent chance of living beyond ninety-two and a 25 percent chance of living beyond ninety-seven. And, if they choose a life annuity, they will be able to spend at the same rate for as long as they live. A life annuity is the only investment vehicle that features this advantage.
Trying to replicate this advantage of a secure lifetime income, but without the risk-pooling of a life annuity, would cost you 25 to 40 percent more money because you would need to set aside enough funds to last throughout your entire possible lifetime instead of just enough to last throughout your expected lifetime.
How much you choose to annuitize will depend on how much you have saved, how much risk you want to spend, and how much you would like to give to others. A sound strategy is to choose an annuity that will give you enough to meet your basic needs for the rest of your life while investing the balance in stocks, fixed-income securities, and money markets. The annuity doesn’t need to meet all your desires; it just needs to meet your basic standard of living. The rest of your money can provide flexibility, protection against surprise expenses, and gifts.
In calculating how much to annuitize, subtract the amount you will be receiving from Social Security and any pension benefits you may have accrued from what is needed each month. Then annuitize a sufficient amount of your assets to provide for the remainder of the monthly income you will need to reach that threshold level. You can purchase a “real annuity” to protect against inflation if you prefer.
To make sure Steve and Anne will always meet their basic needs, the couple may choose to annuitize half of its assets, which now total $1 million, for the rest of their lives. Each month the couple will receive about $1,650, which automatically adjusts upwards with inflation.
You will want to make provisions for any extraordinary expenses, such as uncovered health costs and institutional care. Some annuities will pay out a larger amount at a certain age. So if you need special long-term care when you’re eighty years old, you can choose an annuity that allows an increase in payments then. While annuities with this feature cost more than regular annuities that provide level payments throughout life, they can be well worth the extra cost. You can also purchase supplemental or long-term care insurance to bridge the gap left by Medicare insurance.
When you look for an annuity, choose one of the most financially sound insurance providers. You will be able to sleep a lot better if you’re not concerned about your provider going bankrupt.
Understanding what annuities can do for you may be easy. But to help out even more, let’s dispel some of the myths that commonly surround them.
Myth 1: Annuities cost too much.
Creating an annuity mathematically, or on paper, is easy. You plug in your total investment and interest rate and out pops what you can get each period. This is considered the actuarially fair price. But like most businesses, firms that provide these services charge a fee.
During the past decade, markups above actuarially fair prices have come down from around 6 to 10 percent to less than half that from the top companies, approaching zero in some cases. This one-time fee is less than the 1 to 2 percent fee mutual funds charge yearly. Life annuities offer lifetime income security; mutual funds don’t give any guarantee that you won’t outlive your assets. Of course, if you are unhealthy and have low prospects to regain your health, an annuity purchase may not be the way to go.
Myth 2: Homemade strategies are cheaper.
It takes an insurer to assemble a large pool of thousands of people to fund the payments that go to people who live longer than expected. A large pool is also needed to provide predictability and efficient pricing to the provider of insurance, as well as to the consumer.
It is difficult to form a viable pool if you try this at home on your own. Steve and Anne could choose to invest all of their assets in mutual funds or stocks and bonds, but the chance that they can match the average returns and security of an annuity is small at best. By annuitizing part of their assets, they can ensure they will always have income to meet their needs.
Homemade systems carry a risk of running out of income long before one runs out of life. If everything goes according to assumptions and the plan is followed tightly, there may be only a 15 percent risk—roughly equivalent to the 16.7 percent odds of losing in a game of Russian roulette. But with annuities there’s no risk.
Myth 3: Annuities are detrimental to inheritances.
If you choose to annuitize all of your assets, then your heirs may not receive as much money. Any excess money you received on a monthly basis could be given to them. But if you die soon, there will be very little to pass along. This can be remedied by using some of the extra monthly annuity income to purchase life insurance, which can generate a sizable sum to pass along at death. With annuitization the insurers absorb all of the longevity risk. Without annuitization the heirs absorb all of the risk rather than the insurers.
When you purchase an irrevocable life annuity at retirement, you lose control over those funds—and, thankfully, so do your kids. This provides added security because your financial safety will come before someone else’s desire for your money.
Myth 4: I should wait to buy annuities in case interest rates go up.
Some people delay annuitizing in hopes that they can get higher annuity yields if interest rates increase. Briefly, here are the issues. It is true that if interest rates increase, annuity yields might also increase. But there are some mitigating factors to consider if you’re thinking about delaying an annuity purchase. First, your accumulated assets need to be invested in something during the interim while awaiting the time to purchase a life annuity. If invested in traditional vehicles, such as fixed income and equities, the value erosion that typically accompanies rising interest rates may offset part or all of the gain that one hopes to garner by delaying the annuitization decision. Second, if life expectancy improves beyond the rate of improvement assumed in current pricing, the prices of the annuities themselves will climb.
By covering at least basic expenses with lifetime income annuities, Steve and Anne are able to focus on discretionary funds as a source for enjoyment. Locking in basic expenses also means that their discretionary funds can remain invested in equities for a longer period of time, bringing the benefits of historically higher returns that can stretch the useful life of those funds even further. Income annuities may also be a vehicle that enables retirees to delay taking Social Security benefits until they are fully vested, bringing substantially higher payments at that point.
The key in all of this is to begin by covering all of the basic living expenses with lifetime income annuities. Then, depending on your desire to assure higher consumption levels, you may want to annuitize a goodly portion of the remainder of your assets, while making provisions for extra emergency expenses and, possibly, a bequest.
Article written by Craig Merrill
Photography by Brad Slade
About the Author
Craig Merrill is the Grant Taggart Fellow of Risk Management and the Marriott School’s MBA director. Merrill is also a research fellow of the Wharton Financial Institutions Center at the University of Pennsylvania. He teaches courses on derivatives, financial risk management, and asset/liability management for financial institutions. His current research, with David F. Babbel of the Wharton School, focuses on annuities in retirement planning.