Though the discussion in this chapter could be applied to any annuity offering lifetime income benefits, the focus for now returns to income annuities to keep the discussion more manageable.
Previous chapters have introduced the role annuities can play in retirement income plans. Here we dig deeper into the why and how.
Income annuities provide bond-like returns with an additional overlay of mortality credits. For someone wishing to spend at a rate beyond what the bond yield curve can support, bond investments will essentially ensure that the plan will fail.
Income annuities are actuarial bonds. They provide longevity protection that is unavailable with traditional bonds. Retirees receive the bond yield curve plus mortality credits.
Income annuities are like a bond with a maturity date that is unknown in advance, but which is calibrated and hedged specifically to cover the amount of spending needed by retirees when they are alive to enjoy it.
Since the insurance company providing the annuity is investing those funds primarily in a fixed-income portfolio, we should view income annuities as part of the retiree's bond allocation. There is less of a need for bonds for the remaining nonannuitized assets.
Annuities increase risk capacity because the retiree's lifestyle is less vulnerable to a market downturn. Also, distributions from the stock portfolio can be lessened, reducing sequence risk and helping to preserve the investment portfolio.
Liquid financial assets can potentially be larger later in retirement with partial annuitization. Legacy is not irreversibly harmed. We provide analysis and then dive deeper into questions about how much to allocate to the annuity, how to invest the rest, how to manage inflation risk within the plan, and at what ages to buy annuities and to begin their income.
The question is why a retiree should hold any bonds in the portion of their retirement portfolio designed to cover retirement spending (longevity and lifestyle goals). Premiums for the income annuity are invested in bonds (the insurance company adds your premium to its bond-heavy general account) and provide payments precisely matched to the length of time they are needed.
Stocks provide opportunities for greater investment growth. Individual bonds can support an income for a fixed period of time, but they do not offer longevity protection beyond the horizon of the bond ladder created.
Bond funds are volatile, exposing retirees to potential losses and sequence risk while still not providing enough upside potential to support a particularly high level of spending over a long retirement.
Risk pooling with an income annuity can support a higher level of lifetime income compared to bonds. Stocks also offer the opportunity for higher income without any guarantee that stocks can outperform bonds and provide capital gains during the pivotal early years of retirement.
Income annuities can be viewed as a type of coupon bond that provides payments for an uncertain length of time and that does not repay the principal value upon death.
Another way to think about income annuities is that they provide a laddered collection of zero-coupon bonds that support retirement spending for as long as the annuitant lives.
Much like a defined-benefit pension plan, income annuities provide value to their owners by pooling risks across a large base of participants.
Longevity risk is one of the key risks which can be managed effectively by an income annuity. Investment and sequence risk are also alleviated through the insurance company's more conservative investing and asset-liability matching approach for the underlying annuitized assets.
The payout rates for income annuity assume bond-like returns, and longevity is further supported through risk pooling and mortality credits, rather than by seeking outsized stock market returns.
Longevity risk relates to not knowing how long a given individual will live. But while we do not know the longevity for any one individual, the actuaries working at insurance companies can estimate how longevity patterns will play out for a large cohort of individuals.
The "special sauce" of the income annuity is that it can provide payouts linked to the average longevity of the participants because those who die early end up leaving money on the table to subsidize the payments to those who live longer.
Though it may seem counterintuitive to subsidize payments to others, this act can allow all participants in the risk pool to enjoy a higher standard of living while alive than could be supported with bonds. All participants know that the mortality credits will be waiting for them in the event of a long life.
Meanwhile, sequence risk relates to the amplified impacts that investment volatility has on a retirement income plan that seeks to sustain withdrawals from a volatile investment portfolio.
Even though we may expect stocks to outperform bonds, this amplified investment risk also forces conservative individuals to spend less at the outset of retirement, in case their early retirement years are hit by a sequence of poor investment returns.
An income annuity also avoids sequence risk because the underlying assets are invested by the annuity provider, mostly into individual bonds which create income that matches the company's expenses in covering annuity payments.
In hindsight, those who experienced either shorter retirements or who benefited from retiring at a time with strong market returns would have probably preferred if they had not purchased an income annuity. But income annuities are a form of insurance. They provide insurance against outliving assets.
In the same vein, someone who purchased automobile insurance might wish they had gone without if they never had an accident.
But this misses the point of insurance: We use it to protect against low probability but costly events. In this case, an income annuity provides insurance against outliving assets and not having sufficient spending power late in retirement.
Nonetheless, there is still an important benefit from income annuities even to those who do not make it long into retirement, especially for those who are particularly worried about outliving their assets.
That benefit can be seen by comparing it to the alternative of basing retirement spending strictly on a systematic withdrawal strategy from an investment portfolio.
In order to self-annuitize, a retiree must spend more conservatively to account for the small possibility of living to age 95 or beyond while also being hit with a poor sequence of market returns in early retirement. The income annuity supports a higher spending rate and standard of living than this from the outset.
All income annuity participants, both the short-lived and long-lived, can enjoy a higher standard of living while they are alive than they would have otherwise felt comfortable with by taking equivalent amounts of distributions from their investments.
Upon entering retirement, a retiree has several options in terms of allocating between stocks, bonds, and income annuities. Let us consider a simple example with four different approaches.
Suppose a retiree wants to stretch the nest egg over 20 years and will earn 0% returns by investing in bonds. We could assume higher bond returns, but that would simply complicate the math without any loss of generality for this explanation. Since insurance companies also invest in bonds, higher interest rates would increase the annuity payout rate as well. These bonds allow for spending at 5% of the initial portfolio balance — the sustainable spending rate — every year of retirement, but it leaves nothing to support spending beyond year 20.
Now suppose life expectancy is 20 years and add longevity risk to the equation. Some will not make it 20 years; others will live longer. With the 0% returns, the annuity provider earns from bonds, the provider could still support this 5% spending rate through risk pooling and mortality credits no matter how long a participant lives.
Now suppose the retiree self-annuitizes instead by managing this longevity risk without insurance. This requires picking a planning age one is unlikely to outlive. Suppose the retiree decides to plan under the assumption that retirement will last for 30 years. In this case, to spread assets out over 30 years with a 0% investment return, the spending rate must fall to 3.33%. Note as well, the spending rate could only be 2.5% to support wealth lasting for 40 years. The longer one wishes for the money to last, the less one can spend. In terms of an unintended legacy, if one did live for 20 years, then a third of the assets would still remain with a 30-year plan, or half of the assets would still remain with a 40-year plan.
Alternatively, one could seek an investment return higher than 0% by including stocks. With a fixed annual investment return of 3.1%, the retiree could support the 5% spending rate for 30 years. With a 4.2% investment return, spending could be supported for 40 years. The question then centers around how likely it is for the portfolio to earn these higher rates of return through a stock-heavy focus.
Seeking this higher investment return forces the retiree to accept portfolio volatility with a growing allocation to stocks. Spending from investments further heightens sequence risk. A few poor returns early on could easily derail the attempt to support that 5% spending rate for as long as the plan targets.
Wade D. Pfau is the curriculum director of the Retirement Income Certified Professional designation and a professor of retirement income at The American College of Financial Services. He is also a principal and director for McLean Asset Management.