Health shocks that drive the need for expensive long-term care often arise suddenly and are frequently permanent. This makes the prospect of serious disability in retirement one of the biggest sources of stress for late-career workers as they map out their future income strategy.
As discussed in a new working paper published by the National Bureau of Economic Research, U.S. nursing home costs exceed $100,000 per year in some regions, and government assistance programs such as Medicaid help out only when retirees are largely destitute.
These factors, the paper details, mean that people entering retirement must consider how to balance key trade-offs between consumption and health care cost shocks, using retirement account assets and annuitization. According to the paper’s authors, guaranteed income annuities, especially deferred and variable annuities, can be “quite valuable” for retirees, even when they face health shocks in later life. The use of annuities, they contend, brings both mathematical and behavioral benefits.
The analysis was authored by researchers Vanya Horneff, Raimond Maurer and Julius Odenbreit, all of the Goethe University of Frankfurt, and Olivia Mitchell, of the University of Pennsylvania. Unlike similar prior analyses, their work integrates taxes, required minimum distributions, bequest motives and the possibility of retiree insolvency.
Each retiree, the authors conclude, must decide how much insolvency risk is acceptable in an income strategy. Annuities won’t fit into every retiree's “ideal” approach, but many Americans stand to benefit from purchasing a lifetime income guarantee as a hedge against major risks such as long-term stays in a nursing home.
Who Should Annuitize?
The paper is structured around several main questions, including whether nursing home costs are better financed from assets held in tax-qualified retirement accounts or whether at least some of retirees’ 401(k) plan assets should be annuitized to help cover future costs.
The solution is not necessarily universal across population groups, as noted. Those who are healthier at retirement and with higher levels of educational attainment — and thus higher incomes on average — stand to benefit more from partial annuitization.
“Given current regulatory and tax rules as well as empirical evidence on health transition rates and medical costs in old age, better-educated retirees would do well to annuitize part of their 401(k) assets as they can benefit from longevity protection and earn the survival credit,” the authors suggest.
Conversely, they find, the least educated tend to have little wealth and are at greater risk of entering nursing homes at earlier ages. As such, they prefer to keep their assets liquid to better manage unexpected health care and long-term care expenses for a retirement of a shorter duration. They are also more likely to rely on Medicaid to meet health care spending in retirement.
If So, When?
The paper devotes particular attention to when a deferred annuity should begin paying out.
If benefit payments start too early, the (nonrefundable) premium is more expensive, making investors reluctant to buy the lifetime income product. If benefits begin later, the annuity is less expensive, but too few retirees may survive long enough to receive benefit payments. Likewise, the authors consider how individual retiree characteristics affect planning, such as lifetime labor incomes, sex, mortality patterns, health care risk and bequest motives.
“Our results confirm that better-educated retirees favor annuity payouts deferred to age 80 as they have a longer investment horizon, while the less educated do better with immediate and smaller annuities,” the paper states. “Nevertheless, utility gains for men are lower than for women due to their higher mortality rates.”
Deferred vs. Variable Annuities
The authors also examine the extent that optimal deferring ages would differ for payout annuities with fixed versus variable benefits, where the latter are linked to the return of an underlying portfolio of risky stocks and bonds.
In general, the paper finds, women experience greater welfare gains from variable annuities compared to fixed annuities, with no change in their optimal deferral ages. For men, welfare improvements are smaller but still positive, although their optimal deferral age declines.
“Variable payout annuities would clearly offer higher welfare gains for most retirees relative to fixed annuity options,” the paper suggests. “Overall, then, payout annuities are shown to be quite valuable, even when retirees face health shocks in retirement.”
As noted, annuities are particularly attractive to the better educated who need to protect against greater longevity risk.
“In contrast, we find that the least educated with low life expectancies and a relatively high chance of needing nursing home care early in life have very little (if any) demand for annuities,” the paper details. “Instead, they seek to hold on to their assets and avoid relying on Medicaid and the corresponding severe decline in consumption in the nursing home.”
Conclusions and Considerations
The research should be of interest to many stakeholders, according to the authors, including financial institutions seeking ways to help manage the trillions in assets held by baby boomers as they move through retirement.
“Those offering retirement products such as insurers and mutual fund companies will also find our work useful in designing retirement solutions, as will financial advisors working with clients needing to manage their money in later life,” they conclude. “Our results provide clear guidance about when to purchase these annuities, how much to purchase, and when the deferred benefits should start.”
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