To annuitize or not to annuitize?
Hardly the elegant alliteration of a Shakespeare. But, nonetheless, this remains an urgent question that nearly all retirees and soon-to-be-retirees face at one time or another.
And, despite an enormous amount of ink having been spilled on the question over the last few decades, a consensus answer appears as elusive as ever.
The latest kerfuffle that reminds us how unsettled this question remains appeared recently at Advisor Perspectives, the platform on which financial advisers debate the pros and cons of various strategies and investment products. One of the current debates, now stretching back nearly a month and containing a couple of dozen posts from various advisers, is whether Single Premium Immediate Annuities (SPIAs) amount to anything more than “a great wealth building product but only for those selling them making good commissions.”
SPIAs, just to review, are the most basic of annuities, in which you immediately start receiving an annuity payout that is guaranteed for life. To illustrate, I asked Vanguard to provide an illustration for a single 65-year old male investing $100,000 in a SPIA. According to an email from Vanguard, such an investor would be able to secure guaranteed monthly payments of $565.05 from now until he dies.
One of the specific criticisms recently leveled at SPIAs is that they are the functional equivalent of buying a long-term bond, and most would question the wisdom of investing in long-term bonds when interest rates are as low as they are now. That’s because both the SPIA and the long-term bond are vulnerable to a big uptick in inflation.
To appreciate how vulnerable both investments are to inflation, imagine that inflation averages 5% for the next 20 years. I chose this time frame since that is the life expectancy of a single male aged 65, according to the Social Security Administration. This inflation assumption is more than double what the market is currently expecting inflation to average over the next 20, according to the 20-year breakeven inflation rate.
When using that inflation assumption as the discount rate, and assuming that our current 65-year old annuitant dies in 20 years, the net present value of his annuity is around $84,500. That’s only slightly better than the approximately $79,000 net present value of a 20-year Treasury bond purchased today and held to maturity.
Needless to say, both net present values are well below the $100,000 initial investments in each.
But is this criticism fair? To find out, I checked in with Jeffrey Brown, Dean of the College of Business at the University of Illinois at Urbana-Champaign and director of the Retirement Research Center of the National Bureau of Economic Research. Professor Brown has devoted much of his research over the years to analyzing annuities.
In an email, he acknowledged “that a shortcoming of most SPIAs is that they lack inflation protection.” But, he hastened to add, this “does NOT suggest that zero annuitization is the right amount. Rather, it suggests that one does not want to fully annuitize.”
In any case, he continued, comparing an annuity to a long-term bond is comparing apples to oranges, since “the entire point of an annuity is to insure against longevity risk,” and a bond does not provide such insurance. “There is no other product out there that guarantees an income stream for as long as you live. As has been proven again and again in numerous academic and practitioner papers, having a base of annuitized income is the only real way to ensure a basic level of income that cannot be outlived.”
Professor Brown continued: “It is easy to criticize annuities if you are not required to provide an alternative approach that guarantees one will have sufficient income in the event one lives to 100.” An adviser who doesn’t rely on annuities is either exposing his/her clients “to significant longevity risk, or significant asset market risk, or both.”
What is the right amount to allocate to annuities in your retirement portfolio? The answer, as you can imagine, depends on a whole host of assumptions.
One clue comes from an analysis conducted by David Blanchett, head of retirement research at Morningstar. His focus was on deferred-income annuities, which differ from SPIAs in that their guaranteed payment begins at a later point. After analyzing more than 78,000 possible scenarios, each one of which represents a different series of assumptions, Blanchett found that the average optimal allocation across all scenarios was 30.52%.
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