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.
This story does a nice job of translating the benefits of longevity insurance into investment rates of return. Personally, I find no other financial product that guarantees such high rates of return, conditional on survival.
In fact, this story can be taken one step further. What if my grandmother and her club decided to invest the $500 in the stock market, or some risky NASDAQ high-tech fund, for the next year? Moreover, what happens if this fund or subaccount declines 20% in value during the next year? How much will the surviving bridge players lose? Well, if you are thinking “nothing,” that is absolutely the correct answer. They divide the $400 amongst the surviving 4 and get their original $100 money back.
Such is the power of mortality credits. They subsidize losses on the downside and enhance gains on the up-side. In fact, I would go so far as to say that once you wrap true longevity insurance around a diversified portfolio, the annuitant actually can afford and tolerate more financial risk.
Of course, real live annuity contracts do not work as described above. My grandmothers “tontine” contract is renewable each year and the surviving 96-year-olds have the option to take their mortality credits and go home. In practice, annuity contracts are for life and these credits are spread and amortized over many years of retirement. But the basic insurance economics underlying the contract are exactly as described above.
A natural question to ponder is whether this life-roulette game would yield such high returns at younger ages, perhaps 55-year-olds. The answer is no. The accompanying table provides a rough estimate of the relative magnitude from annuitizingwith true-life annuitiesat different ages. You can see that at age 55, the mortality credits are less than 1%, or a mere 35 basis points. At age 65, the number increases to 83 basis points, still nothing to get excited about.
Putting the numbers in context, if a recent retiree and advisor think they can earn 83 basis points more than the pricing rate used by the annuity vendor, they are better off not annuitizing today and managing the money with a systematic withdrawal plan themselves. This “benchmark” or “hurdle” rate of return can be used to assess the relative benefits from annuitization at different ages. Note that by the mid-80s, it becomes virtually impossible to beat. Its what I like to call “the implied longevity yield.” To put it crudely, too many people are dying.
In sum, pension/life annuities provide a very unique and peculiar kind of insurance. It is virtually the only insurance policy that people acquire during the course of their life but actually hope to use! While we are all willing to pay for home insurance, disability insurance or car insurance, we never actually want to exercise or use the policy. After all, who wants their house to burn down, leg to break or car to crash? Yet, the “insurable event” underlying pension annuities is living a long and prosperous life.
Perhaps this is why the industry has yet to achieve the level of success in marketing and selling these products: They are still accustomed to scaring us. Hopefully, simple tales like the one above can help retirees and financial advisors understand the benefits, risks and returns from buying longevity insurance. I certainly plan to buy itin 40 years.
Moshe A. Milevsky, Ph.D., is an associate professor of finance at York University and executive director of The IFID Centre in Toronto, Canada. His e-mail address is: [email protected].
Reproduced from National Underwriter Edition, October 14, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.