Heres a tale about annuitization and grandmothers
By Moshe A. Milevsky
Most retirees are hesitant to annuitize their variable annuity contractsor for that matter to purchase voluntarily an immediate annuity with their IRA, 401(k) and other liquid wealthbecause they fear losing control and/or believe they can “do better” with other investment alternatives.
Oddly enough, when people in a traditional defined benefit pension plan are coaxed to “switch into” a money-purchase defined contribution pension plan and give up the implicit life annuity, most turn the offer down. Others react violently and litigiously. It seems there is a fog of confusion surrounding the financial benefits from annuitization. To address this, yet keep things simple, I offer the following tale. It illustrates the pedagogical benefits of annuitization and longevity insurance while positioning it firmly within the realm of investment risk and return.
The name of my tale is, “The 95-Year-Olds Bridge Club.” My 95-year-old grandmother loves playing bridge with her 4 best friends on Sundays every few months. Coincidentally, all 5 are exactly 95-years-old, quite healthy and have been retiredand playing bridgefor 30 years. Recently this game has gotten somewhat tiresome and my grandmother has decided to juice up their activities. Last time they met, she proposed they each take $100 out of their purse wallets and place the money on the kitchen table. “Whoever survives to the end of the year, gets to split the $500,” she said. “And, if you dont make it, you forfeit the moneyOh yeah, dont tell the kids.”
Yes, this is an odd gamble, but you will see my point in a moment.
All thought this was an interesting idea and agreed. But they felt it was risky to keep $500 on the kitchen table for a whole year. So, they decided to put the money in a local banks 1-year certificate of deposit paying 5% interest for the year.
What will happen next year? According to statistics compiled by actuaries at the U.S. Social Security Administration, there is a 20% chance that any given member of my grandmothers bridge club will pass on to the next world during the next year. This, in turn, implies an 80% chance of survival. And, while virtually anything can happen during the next 12 months of waitingactually, there are 120 combinations, believe it or notthe odds imply that an average of four 96-year-olds will survive to split the $525 pot at year-end. (I sure hope grandma is one of them.)
Note that each survivor will get $131.25 as the total return on her $100 original investment. This 31.25% return contains 5% of the banks money and a healthy 26.25% of “mortality credits.” These credits represent the capital and interest “lost” by the deceased and “gained” by the survivors.
The catch, of course, is that the average non-survivor forfeited claim to the funds. And, while the non-survivors beneficiaries might be frustrated with the outcome, the survivors get a superior investment return. More importantly, all get to manage their lifetime income risk in advance, without worry about what the future will bring.