Objective Analysis of Life Income Annuity Investing for Retirement

If you are considering a lump investing strategy when you retire, a life income annuity is surely on your list of options. I’ll bet every baby boomer without a pension and with money saved is considering annuities. There is so much to know and read about the costs, risks and benefits of annuities. Insurance companies are scrambling to introduce new annuity products with new and different features. Salesmen are being trained to explain them to confused retirees. Whom do you trust to know whether you should buy an annuity with a lump sum investment?

Recently, I discovered a 2007 paper written by two finance professors at the Wharton School, University of Pennsylvania. It is one of the best and most objective articles I have read that specifically addresses the value to a typical retiree of purchasing a life income annuity. Granted, the research was co-sponsored by the New York Life Insurance Company, but the conclusions and data are hard to argue with.

You should read the entire article (linked below) but first consider these statements by the authors:

[E]conomists have come to agreement from Germany to New Zealand, and from Israel to Canada, that annuitization of a substantial portion of retirement wealth is the best way to go. The list of economists who have discovered this includes some of the most prominent in the world, among whom are Nobel Prize winners.

Studies supporting this conclusion have been conducted at such heralded universities and business schools as MIT, The Wharton School, Berkeley, Chicago, Yale, Harvard, London Business School, Illinois, Hebrew University, and Carnegie Mellon, just to name a few. The value of annuities in retirement seems to be a rare area of consensus among economists.

A recent National Bureau of Economics study, which appeared in the prestigious American Economic Review, demonstrated under much more plausible conditions than had ever been supposed, that full annuitization was optimal for people who had no desire to leave a bequest to their heirs or charitable organizations. It also concluded that for those with bequest motives, substantial annuitization of retirement wealth was still the most prudent way to act.

Considering the recent unexplained gyrations in the markets, combining one or more annuities with our other plans for guaranteed retirement income is more interesting. In particular, an annuity laddering strategy may be the best path for maximizing the benefits of a life annuity while minimizing the risk.

Here is the link to the full article.

Note that the authors recommend using a “minimal level of acceptable retirement income” as a basis for making an initial annuity purpose, taking into account Social Security and other guaranteed income. This is something that I have advocated repeatedly.

Another key point from the research is that unless you’re willing to assume more  investment risk, an individual cannot match the guaranteed income that an immediate annuity can provide. Forget the stock market. Research shows that it can work for you over the long term – maybe – but only if you take on more risk.

What do you think of the conclusions and recommendations from this article?


Comments

  1. Another Reader says

    Isn’t this the same nonsense Pelosi and Obama were using to attempt to force everyone to annuitize their 401(k)’s? There’s not a snowball’s chance in you know where that I would turn over a significant amount of my wealth to an insurance company.

    As I said before, a number of these companies almost went under in the 2008 crisis. Annuity guarantee provisions vary from state to state, and you can be sure they would be watered down if the state governments had to step in in the event of a mass failure of insurance companies.

    Annuities benefit the seller more than they benefit the buyer. The commissions and the hidden fees make them outrageously expensive. Thanks, but I will continue to invest my money in assets I can control.

    In addition, I don’t subscribe to the Monte Carlo simulation model of spending down one’s wealth. I agree with the folks in my parents’ and grandparents’ generations. Never spend the principal, only the income the principal produces.

    • says

      Another reader – No argument about fees but your other arguments are a non-sequitur. If you have the assets to guarantee a baseline retirement income for life without spending principal, then of course you do not purchase an annuity. That would be foolish. Annuity products are for people who are concerned about outliving their income. I don’t know what “assets you can control” you are talking about, but there aren’t many asset classes that carry lower risk than annuities sold by highly rated companies. Don’t tell me real estate – ask Fannie Mae and Freddie Mac about that. Even government pensions are at risk now – ask the Greeks. So for many people who cannot take on more risk, annuities are something that should be considered.

      • Another Reader says

        A ratings agency assessment of company risk is not something I would neccessarily rely on. How did that work out in the MBS market? Highly rated doesn’t mean a thing if these “highly rated” companies fail because of some unpredicted meltdown. And fail they almost did in 2008. Many of the big insurance companies were as close to the edge as the banks were. We just did not hear as much about them after the initial crisis passed.

        If your annuity issuer fails, your annuity is governed by whatever your state guarantee system directs. Kind of like what happens when your corporate employer fails and the pension is taken over by the PBGC. You may not get what you thought you paid for.

        The insurance companies invest in Wall Street and real estate, so they are subject to the same forces the individual investor is. As an observer on the real estate side for almost 30 years, I can assure you they are generally not very smart investors in real estate. I can only assume they are better at paper investments.

        To me, the risk of handing your money over to an insurance company in an irrevocable annuity contract is too high. I want my money invested intelligently and where I have some control. I want to be able to retrieve it from the manager if things change.

        My comment about not spending principal is really an aside. Such a plan would require more assets than most people acquire in a lifetime of working. Most employed people are forced to design a retirement plan that spends down what they have over some time frame. For those folks, maybe some type of an annuity contract for a portion of their assets makes sense. That’s especially true if they never got past paycheck-based financial planning. However, no one should put all their money in one place.

        Fannie and Freddie are not investors in real estate. They are market makers in mortgage capital. In theory they serve a public purpose, to manage or at least smooth the flow of money in the mortgage market. Their gains or losses are not those of a profit-seeking investor (despite the years spent as public companies) and are not relevant.

        I put the majority of my capital in real estate for income, leveraged growth and tax shelter. Real estate is no different that Wall Street in that you need the education and skill to invest successfully and you need to look after your investments personally. For folks who are willing to acquire the education and skill, real estate offers an attractive alternative to some of the income “products” sold by insurance companies.

        • says

          There are several investment-categories that are attractive alternatives to insurance-based income products. Real estate is one of them. But it is all about risk vs. reward. To me, beyond living in a mortgage-free home, trying to meet the basic income needs of a retiree with real estate is a bad idea. Even if you ignore the problems of liquidity or having to chase down deadbeat tenants, no amount of education and skill can eliminate enough of the risk for someone who needs cash flow to eat and keep the heat on.

          As for being forced to spend down principal, I don’t look at it that way. I consider it using what you have when you have it. I don’t invest for my heirs or for the estate tax. I guess I’m selfish that way!

          I don’t see Fannie and Freddie as being irrelevant. They represent the collateral damage flowing from the risk-side of real estate investing. The taxpayers are paying the price.

          Thanks for your comments and expertise. Please stick around!

        • Troy Yeaple says

          To say that insurance companies invest in wall street and real estate shows your complete ignorance of fixed annuity products.
          Fixed annuities are backed mainly by US treasuries with a small mix of real estate, high grade bonds, stock options, etc. Most fixed annuities have over 80% in US treasuries and bonds. The reason for this is the capital reserve requirements placed on them by the DOI.

          • MJP says

            Troy: Here is my response to your naive “no worries” comments: GM, Chrysler, Goldman Sachs, Fannie Mae, Freddie Mac, AIG, plus WaMu and hundreds of other failed banks which had “capital reserve” requirements.

          • Troy yeaple says

            Again your lack of knowledge is apparent. Insurance companies capital reserve requirements are much higher than banks. The DOI usually requires an 80 to 100% capital reserve. Banks because of the FDIC are only required a 3%.
            The other Fannie, Freddie and Chrysler are not insurance companies.
            Most annuity companies carry in excess of 100% capital surplus.
            Your statement again is lacking in facts.

    • Troy Yeaple says

      Try to find anyone who has lost their principle in a Fixed annuity product due to the insolvency of the insurance company and you will find it difficult if not impossible. Insurance company’s have capital surplus requirements they must maintain on all of their insurance policies annuities included.
      When you take the capital surplus requirements, reinsurance and the guaranty association into account your concern is completely unfounded and unsupported by fact.

      • MJP says

        Troy: AIG was too big too fail. Other insurance companies may not be. But you are free to ignore the risks.

        • Troy yeaple says

          Again you ignore the reserve requirements of all insurance companies. AIG’s insurance products were not at risk.
          All insurance no matter if it is on you life, your car, your home etc. are required to carry high capital reserves so that they are able to pay claims. Annuities are the highest capital reserve requirement of all since an annuity is insurance on your income if it is a SPIA or your principle if it is a deferred annuity.
          Tell me again what fixed annuities defaulted in 2008. Its a nice round figure 0.

          • MJP says

            Well, then, in-between selling annuities you should write an article for the WSJ entitled “Variable Annuities Have Zero Default Risk.” Let me know when it is published.

          • Troy yeaple says

            Notice in my comments I refer to FIXED annuities.
            Variables are a different subject.
            I have carried a 6,63 and 26 as acting principle of the office I managed several years ago. Securities, annuities etc all have their place in retirement planning.
            I have read so many articles on better alternative strategies than using annuities. In 2008 where were they? Why did so many people at retirement and approaching retirement not have their assets in these great wonderful better alternatives?
            You still did not answer my question on how many fixed annuities defaulted in 2008?
            Fixed annuity products are an excellent alternative to other fixed products such as bonds, bond funds, CD’s etc. not an entire portfolio cure all. For some reason registered reps, broker dealers and some RIA’s always have the either or approach.

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