My column in the May edition of Creative Edge identified the innovation of the annuity lifetime income rider (LIR) as the solution to chronic underannuitization in America. From scholars to today’s financial pundits, everyone has struggled with the fact that traditional lifetime annuitization (e.g., SPIAs) as the solution to the “income-you-can’t-outlive” problem is used by only a small fraction of the population despite its obvious efficiency and uniqueness. There is no other instrument that can guarantee such income to generally risk-averse seniors (proven theoretically as the maximal strategy by Yarri [1965], Davidoff [2005], and others). Annuities are optimal, because retirees get anywhere from small to huge mortality premiums in their payouts relative to alternative asset returns, depending on age, due to the early deaths of the pool of lives. Yet, this “annuity puzzle” remains.
Explanations for underannuitization include:
- Lack of liquidity needed in the event of catastrophic medical costs
- Bequest motive (no remaining value at death)
- High insurance company loadings
- Belief your family will bail you out if you exhaust assets
- People believe they have longer life expectancy than insurers do (so price is not “fair)
- Social security or pensions substitute for “annuitization”
- Belief that the stock market will outperform a guaranteed annuity payment in low interest environments, with little risk of exhausting assets
Most of these reasons shouldn’t cause retirees to eschew annuitization, just mix annuities and other assets.
The last two reasons are demonstrably fallacious, though still proposed by many financial advisors. As Horneff, Maurer, Mitchell and Dus (2006) succinctly state, such strategies, “… involve(s) a strictly positive probability of hitting zero (assets) before the retiree dies.” The risk of asset exhaustion is real, significant and subject to the “sequence of returns risk” in the equity portfolio, not to mention a retiree’s psychological inability to refrain from making bad buy and sell decisions when markets gyrate.
The conclusions of most modern scholars who have authored papers, from Milevsky and Young (2006), to Giacinto and Vigna (2010), to Babbel (2007) among many, are:
- Immediate annuities exclusively provide the certainty needed to not outlive income.
- Mortality gains inevitably result in immediate annuities beating returns from alternative investments by the mid-70s and perhaps earlier.
- The age at which immediate annuities are superior to alternatives is dependent on your assessment of your remaining lifetime, risk aversion and the Sharpe ratio of equities.
In summary, immediate annuities should edge out a retiree’s bond and equity investments, either instantaneously or gradually until they are predominately in annuities at upper ages. The longer you think you will live, the higher your risk aversion and the less you think equities will outperform interest rates relative to their respective risk, the sooner you should annuitize. Practical tools need to be developed to help trained advisors tailor plans to each individual client based on these academic results. While the public has not yet apprehended these results, they eventually will with your help. Perhaps the solution is already occurring with the advent of an LIR on a deferred indexed annuity.
None of these papers has considered the LIRs on FIAs our agents have become so familiar with the past eight years. However, it is safe to assume that the extra liquidity, maintenance of a bequest (money left over for heirs), and better return relative to equities than a traditional deferred annuity or SPIA will make it even more valuable and lower the age of optimal annuitization. Know that when you provide a client with this valuable product and planning you are on firmer theoretical ground than what you see in the latest issue of a consumer financial magazine.
Mike
FOR AGENT USE ONLY. NOT FOR USE WITH THE GENERAL PUBLIC. 12387 – 2012/7/16