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Monday, November 16, 2009

Retirement income – the axiomatic case for annuities

J.P. Morgan Compensation and Benefit Strategies

Nov 12, 2009

… In this article we lay out the axiomatic case for annuities as the investment instrument for providing retirement income. Summarizing: where, over any particular period, the objectives are to maximize lifetime income without risking the possibility that you will outlive your assets, an annuity (vs. self insurance alternatives) will always provide the greatest income. …

Longevity risk – the unpleasant choices for those blessed with long life

… Longevity "risk" … is the risk of being old and poor. Not, say, age 70 and poor … . Instead, we're talking about being, say, 85 or 90 and poor. … [Poor] because the individual lived longer than he or she expected. The retirement savings have been spent, and the individual now has nothing.

What are the choices?

We are going to consider three different general strategies for dealing with longevity risk:

  • "ignoring" it, that is, depending on someone else (family, Social Security, state welfare systems) to finance it;

  • self-insuring;

  • or buying an annuity.

Ignoring longevity risk

If an individual is old and doesn't have any assets, one (or more) of three things happen. Either he or she: (1) moves in with his or her children or other family; (2) lives off of Social Security; and/or (3) lives on some combination of state welfare programs (e.g., a state-provided nursing home). Let's consider each of these alternatives in turn.

1. Living with family. The retiree may have a large and strong family, with a tradition, for instance, of grandparents living with parents and children. … [He] or she is also likely to have a positive motive in favor of preserving retirement assets for a legacy. If the individual does not have family members he or she can realistically live with, then alternative 1 is not a solution to longevity risk.

2. Living off Social Security. … In 2009 [the maximum] benefit is about $2,300 per month. If the individual lives in a low cost-of-living community and is prepared to get by on "very little," then alternative 2 may work.

3. State welfare. Finally, some states and municipalities have quite livable publicly funded "old age" homes. … At least at this time, in this country, there is still a safety net.

Realistically, if the individual is going to ignore longevity risk, i.e., not insure (either with an insurance company or self-insure) against outliving personal retirement resources, he or she is probably counting on some combination of alternatives (2) and (3) and perhaps, depending on family circumstances, alternative (1). …

What is self-insurance?

… Let's assume that you are primarily concerned about the risk of living to age 95. If you live past 95, then somebody is just going to have to take you in. … In that case, self-insuring simply means spending your resources at a rate that (more or less) insures that you will have income through age 95. …

… For purposes of this article we're going to assume that the typical individual, at 65, assumes that he or she is going to live into his or her 80s and is prepared to consider, at least, self-insuring for that period – say, 20 years. So that the individual will spend his or her resources at such a rate that they will last at least until age 85.

What is an annuity?

As we use the term in this article, an "annuity" is a guarantee by some other entity (e.g., a pension plan or an insurance company) of a specific income "for life," that is, with payments beginning on some date and continuing until you die.

Rate of return

… For purposes of this article we're going to assume the same investment return (generally 5% per year) for all purposes: whether you're ignoring longevity risk, self-insuring or buying an annuity. …

… This is not the place to discuss alternative return strategies. Suffice it to say, identical alternative return strategies can be pursued either via self-insurance or an annuity vehicle, that is, in a variable annuity. Thus, the return strategy itself should not affect the relative efficiency of self-insurance and annuities. As a general matter, our conclusions hold whatever rate of return you assume, provided it is the same for whatever longevity risk strategy you pursue.

Comparing alternatives

Let's now quantify the financial alternatives available for mitigating longevity risk – self-insurance vs. annuity.

Let's assume you have $1 million, are age 65 and in average good health. … Let's consider four alternatives: (1) you self-insure for the period age 65 to 85 and disregard longevity risk thereafter; (2) you self-insure through age 95; (3) you self-insure for the period age 65 to 85 and buy an annuity for the period after age 85; or (4) you buy an annuity beginning at age 65 (the number provided here is for a DB plan, not a retail annuity).

The following table summarizes the results for each alternative.

Alternative--Income per month

Self-insurance age 65 to 85--$6,512

Self-insurance age 65 to 95--$5,279

Self-insurance age 65 to 85 + annuity 85-death--$6,091

Immediate annuity beginning at age 65 DB plan--$6,945

Explaining these results

…Self-insurance age 65 to 85 – means you spend all your money, at a rate of $6,512 per month, to age 85. If you live past that age, someone else has to pay your living expenses.

Self-insurance age 65 to 95 – means you spend all your money, at a rate of $5,279 per month, to age 95. As discussed, this is more or less the equivalent of fully self-insuring longevity risk, that is, survival past age 95 can be realistically ignored.

Self-insurance age 65 to 85 + annuity 85-death – means you take some of your $1 million (about 6-7% to be precise) and buy, at age 65, an annuity that is payable for life beginning at age 85. This annuity is relatively cheap, because it doesn't pay anything unless you at least survive to age 85. You then take what's left over and spend it, at a rate of $6,091 per month, to age 85.

Immediate annuity beginning at age 65 – means just a regular old garden variety life annuity. As indicated, our immediate annuity number is based on what you would get out of a DB pension plan using current "standard" actuarial assumptions. Insurance company and regulatory overhead will add costs to annuities and bring the annuity income number down somewhat.

Tax effects

In our analysis we have generally disregarded tax effects. And, assuming our $1 million starts out in a qualified plan or IRA, taxation under self-insurance or an annuity will be, for the most part, identical. We say, "for the most part," because we have ignored two elements of the tax code that, in fact, further skew results in favor of annuities.

First, money held in a qualified plan or IRA, unless it's rolled into an annuity, must be distributed at a specific minimum rate (with a lot of oversimplifications, over the participant's life expectancy). At a stretch, those minimum distribution rules would permit a distribution over 20 years, i.e., allowing self-insurance over the period age 65 to 85. They would generally not permit distribution … under an age 95 self-insurance strategy, some tax-advantaged money would have to be distributed early and held in a taxable account.

Second, the after-tax rate of return on a taxable account (e.g., a garden variety bank or brokerage account) will be lower than the after-tax rate of return on a retail annuity. That's because the "inside build-up" on retail annuities is untaxed. …

When you put these two rules together, the annuity approach enjoys a tax advantage vis a vis self-insurance. Nevertheless, we regard that advantage as relatively marginal and have not taken it into account in our analysis.

Why are annuities such a better choice?

…Given those two objectives, maximizing retirement income and minimizing the chance of outliving your savings, annuities are the most efficient investment because – all other things being equal – they share the risk of outliving savings within the annuity pool. …

*     *     *

… Reviewing it, you would think that everyone would buy one. But the fact is, very few individuals do. Consider – only 2% of the income of current retirees comes from private annuities. (Increasing Annuitization in 401(k) Plans with Automatic Trial Income; Gale, Iwry, John and Walker; 2008.)…

Compromised longevity

The foregoing, "axiomatic" case for annuities holds for someone in average good health. Clearly, if you realistically expect not to live to an average life expectancy – that is, your longevity risk is, for some reason, compromised – then you should generally not buy an annuity. …

Solvency risk

If you take the annuity approach, then a third party will be paying you an income for life. Generally that third party is either an insurance company or an employer-sponsored pension plan. Both insurance companies and (corporate) pension plans are subject to solvency rules – requiring them to fund benefits at certain minimum levels. Moreover, many states provide insolvency funds for insurance companies that go "bankrupt," and the Pension Benefit Guaranty Corporation generally insures corporate pension benefits up to certain minimum levels.

…Suffice it to say, if you are taking an annuity option, you will want to evaluate the possibility that, under some circumstances, the third party annuity provider might not be able to make payments.

Explanations focusing on aspects participant behavior

Concerns about compromised longevity and carrier insolvency risk cannot, however, explain the overwhelming rejection of annuities by participants. …

In recent years, the field of “behavioral economics” has provided insights as to why individuals do not always act in accordance with “rational” principles. … While we recognize the fruitfulness of this perspective, we are resistant to the idea that low uptake on annuities is simply a result of irrational decision-making. …

Individuals view early death as "losing" in an annuity system

If you look at the actuarial tables, over 15% of a typical age 65 annuity cohort will die in the first ten years. They will "lose" – by dying early – a significant portion of the value of their benefit. We put "lose" in quotes because the axiomatic argument does not regard this as a loss. The participant is dead and so does not need any more income. And the participant could have had no fixed legacy intention with respect to the "lost" money – if (as was in fact more likely) he or she had lived to a normal life expectancy, there would have been no money "left over" to leave to heirs and beneficiaries.

Our guess, however, is that people don't think like that. …[Human] beings are reluctant to take a substantial risk that money they worked hard for will simply go to strangers, even after they're dead. … Humans retain, and act on, a proprietary view of their money, even after their (anticipated) death. …

Annuities limit flexibility

Simply, if money is "locked up" in an annuity, there is no (or, at least, less) money available for emergencies or, for that matter, for something special.

Individuals place a lower value on life after 85

… More nuanced: a 65 year old does not regard the financial challenge presented by living past 85 as a particularly high priority. Perhaps an analog to this is the reluctance of young people (say, individuals in their 20s) to buy health insurance. In both cases, the likelihood of catastrophe – a health catastrophe for a young person or a longevity catastrophe for an old person – is small enough that the individual feels comfortable ignoring it. (This argument reflects the behavioral economics notion of “hyperbolic discounting.”)…


This is a publication of J.P. Morgan Compensation and Benefit Strategies. J.P. Morgan Compensation and Benefit Strategies is a part of JPMorgan Chase & Co. If you have any comments or questions, please contact your J.P. Morgan Consultant or Insight Editorial.

This material has been prepared for informational and educational purposes only. It is not intended to provide, and should not be relied upon for investment, accounting, legal or tax advice. J.P. Morgan Compensation and Benefit Strategies is wholly owned by J.P. Morgan Retirement Plan Services LLC, an affiliate of JPMorgan Chase & Co.

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