Why Buy Annuities?
Two primary reasons: group insurance and longevity protection.
Two primary reasons: group insurance and longevity protection.
Tuesday’s column, "Making Annuities More Attractive," addressed how annuities are marketed. I advised that they be renamed as “guaranteed income” offerings (“annuity” being a term that only an actuary could love); that they calculate and publish their expense ratios; and that the cacophony of state regulations be simplified into a single, national code. These recommendations, of course, are unsullied by expertise. I did not commission a market-research study on the subject.
That said, I think those proposals are on track. In particular, annuity providers need to address the deep distrust that they have instilled among the most-informed buyers. A business school professor emails: “The two words that always come to my mind when I think of annuities are 'rip off.' I don’t think that providers will ever publicize an expense ratio because their jig will be up.” As word-of-mouth advertising goes, it is hard to do much worse than that.
Today’s column addresses annuities’ investment merits (which they had better have, otherwise there would be no point in improving their marketing). In this endeavor, I can claim some genuine competence—although the insights are not directly mine, but rather purloined from Morningstar’s retirement-methodology team, which researches such things. This article is a team endeavor.
We’ll start by setting aside deferred-variable annuities—normally called simply “variable annuities.” For this article, though, I will label them as “deferred variable annuties” to distinguish them from immediate variable annuities. Writes Morningstar’s Paul Kaplan, “The first conference I attended after Morningstar was a Deferred Variable Annuity conference. The opening speaker was former NY governor Mario Cuomo. He said that after hearing what a deferred variable annuity is, he won’t buy one.” While Paul doesn’t take investment advice from politicians, he appreciates the governor’s view. To start, deferred variable annuities are neither fish nor fowl—not exactly an investment fund, also not quite an annuity in that the assets have not be irrevocably exchanged for an annuity contract. To finish, they often come with high expenses, and a bevy of complex features.
So, no thanks. There may be a good case to make for a low-cost, relatively simple deferred variable annuity. However, that will not be the subject of this column.
Instead, the topic will be the uses of single premium immediate annuities (SPIA), which begin their payouts immediately after purchase, and advanced life annuities, which start their payments at some specified future date. The differences in distribution rates between those two versions can be dramatic. Morningstar’s David Blanchett tracked down the best current available rates on lifetime annuities for a single 65-year old male. The immediate annuity pays 6.25% per year. With an advanced life annuity that starts payments in 10 years at age 75, balloons annual payout* to 13.75%.
*I use the term “payout” rather than “yield” or “income” because, effectively, these single premium annuities include return of capital in their distributions. Which means that, yes, my proposed label of “guaranteed income” isn’t strictly accurate. Perhaps “guaranteed payments” is a better suggestion.
The Group’s Advantage
The main benefit of an SPIA is straightforward. As financial planner Michael Kitces explains, SPIAs turn an uncertainty into a near-certainty. Forecasting the life expectancy of a single retiree, or even a married couple, is a highly uncertain task. The date may arrive tomorrow, or in 35 years. Mapping out the distribution of life expectancies for a large number of people, however, is a routine duty for those trained in such matters. It can be done with high reliability.
Because groups can be modeled with much more certainty than individuals, they can be insured more efficiently. In layman’s terms, this means that the person who buys an SPIA can achieve a higher lifetime payout rate than he can by purchasing government securities—as with, for example, a bond ladder.
Of course, this benefit only remains a benefit if it is priced appropriately. It is certainly possible for an SPIA to carry such high costs that the prospective buyer would be best off forgoing the advantage of pooling with others, because the expenses of doing so outweigh the prospective gains. Happily, that is not currently the case with SPIA pricing; when Blanchett surveyed today’s annuity quotes, and compared their payouts against what investors could achieve by buying Treasuries, he found that the leading SPIAs do indeed offer better payouts than would a self-insured portfolio.
(The reason for the SPIA’s higher payout owes to something called “mortality credits”—a topic that I will bypass for this column. For those interested, it is well covered in the Kitces article, to which I linked above.)
The drawback of SPIAs is well known, major, and oft-lamented: The money disappears upon the purchaser’s death. This makes SPIAs ill-suited for those who wish to leave substantial legacies. (Some annuity providers attempt to assuage such fears by bundling death benefits into their offerings, but the costs of such benefits often cut so deeply into the annuity’s payout that the product is no longer attractive.) Most retirees, however, do not have that happy problem.
Most SPIAs have fixed payments; others have variable payments; and a third, less-common flavor adjusts the payouts for inflation. Morningstar’s researchers have no preference among the first two varieties, except to suggest that fixed annuities be used to fund essential purchases, while variable-payout SPIAs (not to be confused with the previously discussed “deferred” variable annuities—see how confusing the industry’s terminology can be?) should cover lifestyle consumption. It is probably best to skip the cost-of-living option as that usually comes at too high a price.
The final use for annuities—assuming, as always, that they are priced correctly—is for deferred income. Should the retiree live longer than she ever expected, the payments from an advanced life annuity could fill what would otherwise be an income gap. Such annuities take the concept of insurance in the opposite of their normal direction. In the case of the advanced life annuity, the “problem” that is to be insured is the event of living an unusually long life. As problems go, there are worse!
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.