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By Christine Benz | 08-10-2011 08:48 AM

Why Annuities Often Make Sense

By allowing retirees to pull extra income out of a nest egg, annuities will be a key component of most people's retirement strategy, says Nobel laureate Robert Merton.

Christine Benz: So, one other issue I want to discuss with you is when people exit the 401(k) setting, they are in retirement, and they are trying to figure out how to draw down their assets. Do you have any thoughts on how that process might be handled better? Are there any guardrails that could be put in place to help people in that position?

Robert Merton: That's a very good question, and it's quite important. One because of course the end result of all of this is to take care of people in retirement, and if you get all the way through the accumulation phase and then don't use the funds you have accumulated in a way it's best, you have sort of lost out in the last leg of the race. And also because people are living longer in retirement, their lifestyles change.

Benz: Cognitive functioning also declines pretty significantly after a certain age and so people are managing these assets when they are maybe not in a position to do it well.

Merton: I think it's a process that begins during the accumulation period. I don't believe in formal education for people; it's not reliable in the sense that people are going to go and read books. Some will, some won't. Some will understand it. What I think is that, for example, in the Dimensional Managed defined-contribution plan that we do, the targets and everything that are expressed to people are always expressed in terms of income in retirement, not a set amount of wealth, or we'd never mention a rate of return. So, there is a certain amount of income.

Now, if people have gone through that system through many, many years in the accumulation period, it is more likely, not assured, but more likely when they get to retirement that their mindset is going to be about getting that amount of income or some amount of income. They'll be income-oriented. If instead, as is done typically now, the focus is on the amount of money…

Benz: Getting that kitty to be as large as you want it to be.

Merton: Yeah, and you get there, then to say by now you need to switch to thinking about income, it's like anything else--that's not going to be, I think, as effective. So, part of it really begins in the right mindset. Now, when you get there, we target in our solution a stream of income for life, which is like a annuity--that may you live to 120 we'll cover you--that's protected for inflation, so that it can preserve the standard of living at that level.

When they get there, if we've done our job they'll have enough to purchase that annuity, once they retire, from a highly rated insurer or several of them. But they don't have to, and it may not be the best to answer for everyone. So, you can still take any or all of that money and use it for other things. You can invest it in different things; there are all kinds of plans. There are notions of buying tail insurance should you live so long. So, sometimes what people do is they've suggested if they retire at 65 that they buy annuity that starts at 85.

Benz: Longevity insurance?

Merton: It's longevity insurance, and then they live off that. That's a certain possibility and will fit some people's needs, and it's clear that people will have probably a need for some amount of cash that they can have access to, that they might need for an emergency and so forth. That said, I still think that for the vast majority of people working in the middle class who are not poor, they are doing fine. But they don't have a lot of extra money--as if anyone does, but you know what I am saying--they are going to find that the so called mortality credit of an annuity is going to be very difficult not to use at least to some large extent.

And what I mean by that is the following: If you have a certain amount of money at your retirement, again let's just say $1 million so I can talk about it, and if the interest rates protected for inflation--what we call real rates--were 2%, then just holding that money and locking and buying this and holding onto it, they can earn 2% or $20,000 a year.

Benz: In a certificate of deposit or something like that?

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