An annuity is a stream of monthly income guaranteed for
life, starting immediately or deferred to a specified time
in the future, in exchange for an upfront lump sum payment.
For example, a woman of 65 investing $500,000 can receive
about $2700 a month starting immediately, $3900 starting in
5 years, or $5900 starting in 10 years. The 5 and 10 years
are the deferment periods, which can be as long as 25 years.
These are stand-alone quotes, meaning that the
annuity is not tied to any other feature of the annuitant’s
retirement plan. In my view, annuities are best deployed as
one part of an integrated plan in which part of the
retiree’s assets are used to purchase a deferred annuity,
and the balance is used to live on during the deferment
period. My colleagues and I have been developing the
technology for such a plan, called the Retirement Income
Stabilizer (RIS), which I will be writing about in the
months ahead. But this article is about misperceptions of
annuities in general.
A major misperception is that annuities are a bad
deal because the rate of return credited to them by
insurance companies is substantially lower than the return
available to a retiree on the same amount invested in
equities. Insurers invest primarily in fixed-income
securities, which over long periods yield less than
equities.
Annuity payments, however, are also affected by the
mortality of purchasers. The insurer stops paying annuitants
who die, leaving more for those still living. On Dec. 21,
2018, I measured the mortality effect using RIS. The
hypothetical annuitant was a 65-year old woman who had a
nest egg of $1 million of common stock and .wanted it to
support her to age 104 if necessary.
I found that if she used part of her nest egg to
purchase a deferred annuity, and the remainder to live on
during the deferment period, she would receive $4260 a month
starting immediately, rising by 2% a year. For the nest egg
to support her without the annuity, it would have to earn a
return of 6.2% to 6.5%, depending on the length of the
annuity deferment period used in the calculation. Those
rates can be viewed as the return paid to the annuitant
taking account of mortality.
A quick proviso. Those returns are available only
to an annuitant who has shopped the market, as I did. The
annuity amount referred to above was the highest offered by
the 11 companies for which I have data.
Another critical difference between a retirement plan that includes an annuity and one based entirely on draws from financial assets is that annuity payments are guaranteed where investment returns are not. The 65-year old retiree with a portfolio of common stock is probably going to earn more than 6.5% on it over the next 39 years, but may not. Over the 577 39-year periods between 1926 and 2012, the median rate of return was 7.8%, but during 2% of those periods the return was 4.7% or less. If that came to pass, the consequence of impoverishment at an advanced age is horrendous. An annuity provides insurance against this low-probability hazard.
