The “A” word strikes fear into the hearts and wallets of advisors throughout the financial services industry. Irreversibly handing over a lump sum of money — to an insurance company, no less — in exchange for a promise to slowly return this money over a very long period of time rightfully feels like financial suicide to many retirees.
Ironically, the loathed process of annuitization is at the core of defined-benefit (DB) pensions — a steady generator of retirement income, which is cherished by retired civil servants around the world — and helps mitigate longevity risk, something I discussed in last month’s lesson. In fact, the lifetime-income guarantee from Social Security is also based on the annuitization process. You can’t securitize, cash-in or monetize your income stream, although it definitely lasts for the rest of your life.
So which one is it then? Is voluntary annuitization to be shunned and avoided or is it the foundation of a well-balanced retirement income plan? In this month’s lesson I will provide a closer look at the pros, the cons and some of the fixes. Indeed, if you are going to accept annuitization as a partial solution for your client’s retirement income, then you should understand the mechanics of how and when it works. Likewise, if you plan to bypass this approach as a viable solution, it makes sense to talk intelligently about its shortcomings.
The ProsTable No. 1 displays sample quotes for single premium immediate annuities (SPIAs) in mid-June 2007. Each column contains the top five quotes from five different insurance companies for a given purchase age and gender. These numbers are provided by an intermediary called CANNEX Financial Exchanges, which is attempting to provide the equivalent of a stock exchange quoting-system for retirement income products; more on that later.
What Your Peers Are Reading
Here is how to read these numbers: If your 65-year-old female client invests or deposits $100,000 in a SPIA, then the best insurance companies offer a range of $643 to $641 per month for life, pre-tax of course. Note that this income stream will completely cease upon death. Indeed, if she dies 10, five or even one year into the annuitization period, everything is lost.
Naturally, most if not all people select a guarantee period for their SPIA, for which they receive a slightly lower income stream. For example, as shown in the table, if your 65-year-old female client selects a 10-year payment certain (PC, as they are often called), the income is now lower; the top company range is $627 to $625 per month. A 65-year-old male gets slightly more. His numbers range from $670 to $663 if he selects a 10-year payment certain and $697 to $688 if he does not.
On a slightly more technical level, if you divide the annual income generated by the basic SPIA by the initial premium of $100,000, you arrive at what I call the annuity yield. For example, using payouts from the table at age 65 — with zero years of certain payments — the best company yields range from 8.36 percent to 8.26 percent for males and 7.71 percent to 7.69 percent for females.
These numbers have remained steady at these levels over the last two to three years, but longer term they have been declining as a result of both historically low interest rates as well as increasing longevity. As people are projected to live longer, the insurance companies can’t offer as much.
The figure below illustrates the weekly evolution of annuity yields over the last two years. I have plotted the best/worst annuity yields for both males and females offered by insurance companies in the U.S. that are part of the CANNEX system — in comparison to the yield on a 10-year government bond.
There are a number of important insights to be gleaned from this chart. First, notice that the yield — which is the annualized income stream divided by the initial premium — is much greater than the yield on a government bond. The reason for this is because your lifetime income is an integrated blend of three distinct cash flows. First, you are getting a type of interest coupon on your money; second, you are getting a portion of your premium back; and third, you are getting a portion of other people’s money. In fact, for this reason it’s a bit of an apples-and-oranges situation to compare the unique yield of a life annuity to any fixed-income instrument.
The insurance actuaries try to forecast approximately how many people will die in any given year (and they take into account the risk of getting this calculation wrong), and then give the annuitant a “longevity credit” based on this estimate. Of course, all of this alchemy takes places behind dark curtains since the annuitant receives a constant periodic check that blends all of these varying components.
Notice also another subtle fact. The spread between the highest/lowest quotes, i.e., what the most competitive versus least competitive insurance company is offering appears to be shrinking over time. In other words, the gains from shopping or the dispersion between companies is on the decline. The decline reflects a market that is becoming more commoditized and more competitive. And, although insurance companies might not welcome this trend, the end-user can only benefit. In fact, the availability of various annuity quoting websites — and the CANNEX Financial Exchange which provides a transparent platform for users to see quotes in real time — helps accelerate this trend.
Back to our discussion of the pros of annuities, SPIAs and their financial cousins provide lifetime income that cannot be outlived. They also provide a mechanism for pooling, sharing and hedging longevity risk over a large population, which leads to a higher yield for surviving annuitants. Finally, they provide stable and predictable income that is not subject to the vagaries of the stock market. It’s a fixed-income product together with a longevity coupon “kicker.” It’s important to remember that if you die prior to reaching a financial break-even point, the insurance company doesn’t keep the money — rather, it goes to subsidize payments for those who exceed the averages.