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April 04, 2010 at 08:00 PM
While longevity risk has started to get a lot more attention as an abstract notion, the sales of single premium immediate annuities, which are meant to protect against this risk, remain quite modest. Could it be that the value proposition for SPIAs needs to be better understood?
To appreciate the importance of longevity risk, take a look at what is happening in Europe. Recently, several pension plan managers eliminated longevity risk in their pension plans by transferring the mortality risk to insurance companies. Some of the insurers have in turn reinsured part of the risk to reinsurers. It is now expected that there will be more such transactions throughout Europe. If the managers of these pension plans–plans large enough to mute the impact of any one person’s longevity–are concerned about longevity risk, it seems that individuals responsible for their own retirement incomes should also be concerned about it.
For some perspective on this, let’s compare the numbers (such as fund values and payout amounts) between SPIAs and a fixed investment account.
The comparison centers on the interest rate and mo
rtality risk, although it admittedly ignores liquidity risk, a notable drawback of many SPIA designs. This simple comparison, which ignores taxes for the sake of simplicity, looks at a 65-year-old male who is purchasing a SPIA versus a 65-year-old male who keeps the money in a fixed investment account.
In the current interest rate environment, fixed investment accounts are crediting around 3.75%, and a reasonable SPIA monthly payout rate for a 65-year-old male is $6.95 for a $1,000 deposit.
If the man seeks a $5,000 monthly lifetime payment for retirement, it will cost him $719,424 to purchase a SPIA. On the other hand, if he deposits the same amount into an investment account with a 3.75% interest rate and makes systematic withdrawals of $5,000 a month, the investment account will run out of money before the man turns 81.
This example assumes the investment rate stays constant at 3.75%. If the interest rate drops to 2.75% after one year, the investment account runs out of money before the retiree turns 80. If the interest rate increases to 4.75% after one year, the investment account runs out of money when the retiree is 82.
In contrast, the interest rate for the SPIA is effectively locked in at issue and embedded in the payout rate.
As shown in this example, interest rate movements of 1% do not have a dramatic impact on the duration of the investment account.
