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David Blanchett

Retirement Planning > Retirement Investing > Annuity Investing

Here's What Makes an Annuity 'Optimal' for Clients

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What You Need to Know

  • Differences in demand and life expectancies for different types of annuities can potentially affect expected income levels.
  • Annuities with higher demand among households could potentially improve pricing based on increased market competition.
  • Adjusting mortality rates or expense load assumptions can significantly affect expected income levels for an immediate annuity.

The attributes of people who purchase a given insurance product (e.g., an annuity) can significantly affect the expected benefits of that product. Specifically, differences in demand (i.e., total sales) and life expectancies (i.e., mortality experience) for different types of annuities can potentially affect expected income levels.

While this point is relatively obvious, I’m not sure it is fully appreciated by everyone in the decumulation space when estimating the efficiency of different annuities.

The “optimal” annuity cannot be determined in isolation, and strategies that balance behavioral and economic efficiencies are likely going to end up being the ones that provide the greatest benefit to retirees.

A Hard Sell

The lack of annuitization among Americans is well-known and contrary to the consensus among economists. Many note that holding retirement assets in an annuity-type structure is more efficient than withdrawing from an investment portfolio during retirement to fund consumption given an uncertain lifespan (i.e., self-annuitization).

The lack of demand for annuities is due to a variety of factors, one of which is product design. Early annuities, such as single premium immediate annuities (SPIAs), which are especially common in retirement research, require an irrevocable transfer of the insurance premium for the promise of lifetime income.

This is a difficult “trade” from a behavioral perspective. Deferred income annuities (DIAs) — in particular, qualified longevity annuity contracts (QLACs) — represent an especially difficult purchase, given the delay from purchase to income commencement. Though widely touted among retirement academics, they remain relatively muted.

Not surprisingly, combined sales of SPIAs and DIAs are relatively low in terms of total annuity sales, representing 3% of the total in 2021 based on an analysis by LIMRA.

While total sales for SPIAs and DIAs in 2021 would still be relatively larger given the absolute value (at $6 billion and $2 billion, respectively), there are clearly other annuities with higher demand among households (e.g., variable annuity strategies with some living benefit) that could potentially improve pricing based on increased market competition.

Mortality Experience

Mortality experience also differs across annuities. This effect is demonstrated in the graph below, which includes mortality experience data from the Society of Actuaries 2009-2013 Individual Payout Annuity Mortality Experience Report for deferred and immediate annuities and the Ruark 2018 Variable Annuity Industry Mortality Experience Study for variable annuities.

For context, the lower the ratio, the healthier the respective annuitants (and vice versa).

Behaviorally efficient annuities

Annuities with lower “commitment” levels tend to have annuitants that are less healthy, on average. For example, individuals who purchased variable annuities, which are typically fully liquid (and revocable) had mortality rates that were consistent with annuity mortality tables, while mortality rates among annuitants in DIAs were less than half of expected mortality rates.

This is not necessarily a surprise, since only an especially healthy individual would be expected to purchase a DIA, given the structure of income payments. However, these differences have important implications for pricing. For example, since individuals who purchase DIAs are notably healthier than those who purchase VAs with a living benefit, the payouts for DIAs (based on the pure mortality component) would be lower, ceteris paribus.

Ignoring some of the structural differences in annuities (e.g., around mortality rates) can result in an incomplete perspective on the relative efficiency of different annuities. To demonstrate this effect, I analyzed what happens when some of the key pricing assumptions for an immediate annuity are adjusted, in particular the assumed expense load and mortality rates.

More formally, I determined the payout rate (income amount dividend by initial premium) for an immediate annuity for a 65-year-old male, assuming Gompertz factors fit to mortality rates from the Society of Actuaries 2012 Individual Annuity Mortality table with improvement to 2022 and a 5.5% discount rate. (This is consistent with the yield on 10-Year High Quality Market Corporate Bonds as of Dec. 5, 2022, based on data from the St Louis Federal Reserve.)

Assuming a 10% expense load, the payout rate would be 7.15%, which is consistent with the median quote available from CANNEX.

The tables below include how the adjustments affect the payout rate for either a life-only immediate annuity or for an immediate annuity with a cash refund provision. Technically, for the model, I adjusted the modal coefficient in the Gompertz factors to capture the impact of a life expectancy change.

Mortality Rate for Annuities

Adjusting mortality rates or expense load assumptions can significantly affect expected income levels for an immediate annuity (for better or worse).

For example, if we focus on life-only annuities (Panel A), attracting a cohort of annuitants that have a life expectancy that is two years shorter, on average (i.e., trending more like the general population, which has a life expectancy that is about five years shorter than the average annuitant) with a 5% assumed expense load (versus a base 10% assumed load) would result in an income level that is 10% higher than the base scenario.

Additionally, while including a cash refund provision to an immediate (life-only) annuity would generally be expected to reduce the benefit level (e.g., by 4.5% for the base scenario), the actual impact is going to depend on the expected attributes of the annuitants.

To the extent cash refund annuities can be issued at a lower cost (i.e., lower expense load) and attract a pool of less healthy annuitants, it would technically be possible to have higher payout rates for cash refund annuities versus life only annuities, something that has been observed in the past based on the quotes available from CANNEX.

Consider the Nuances

While preferences can change over time and be influenced through choice architecture (e.g., defaults in a defined contribution plan) it is naïve to assume the underlying mortality and expense components for different types of annuities are identical.

In reality, truly optimal strategies are going to be those that blend behavioral and economic considerations. The best strategies may require some type of “compromise” when viewed entirely from an economic lens, but ignoring market realities is not going to result in the best outcomes for retirees.


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