An annuity is a stream of monthly income guaranteed for life, starting immediately or deferred to a specified time in the future, in exchange for an upfront lump sum payment. For example, a woman of 65 investing $500,000 can receive about $2,700 a month starting immediately, $3,900 a month starting in five years, or $5,900 a month starting in 10 years. The five and 10 years are the deferment periods, which can be as long as 25 years.
These are stand-alone quotes, meaning that the annuity is not tied to any other feature of the annuitantās retirement plan. In my view, annuities are best deployed as one part of an integrated plan in which part of the retireeās assets are used to purchase a deferred annuity and the balance is used to live on during the deferment period. My colleagues and I have been developing the technology for such a plan, called the Retirement Income Stabilizer (RIS), which I will be writing about in the months ahead. But this article is about misperceptions of annuities in general.
A major misperception is that annuities are a bad deal because the rate of return credited to them by insurance companies is substantially lower than the return available to a retiree on the same amount invested in equities. Insurers invest primarily in fixed-income securities, which over long periods yield less than equities.
Annuity payments, however, are also affected by the mortality of purchasers. The insurer stops paying annuitants who die, leaving more for those still living. On Dec. 21, 2018, I measured the mortality effect using RIS. The hypothetical annuitant was a 65-year old woman who had a nest egg of $1 million of common stock and wanted it to support her to age 104 if necessary.
I found that if she used part of her nest egg to purchase a deferred annuity and the remainder to live on during the deferment period, she would receive $4,260 a month starting immediately, rising by 2 percent a year. For the nest egg to support her without the annuity, it would have to earn a return of 6.2 percent to 6.5 percent, depending on the length of the annuity deferment period used in the calculation. Those rates can be viewed as the return paid to the annuitant taking account of mortality.
A quick proviso: Those returns are available only to an annuitant who has shopped the market, as I did. The annuity amount referred to above was the highest offered by the 11 companies for which I have data.
Another critical difference between a retirement plan that includes an annuity and one based entirely on draws from financial assets is that annuity payments are guaranteed where investment returns are not. The 65-year-old retiree with a portfolio of common stock is probably going to earn more than 6.5 percent on it over the next 39 years, but may not. Over the 577 39-year periods between 1926 and 2012, the median rate of return was 7.8 percent, but during 2 percent of those periods the return was 4.7 percent or less. If that came to pass, the consequence of impoverishment at an advanced age is horrendous. An annuity provides insurance against this low-probability hazard.
ABOUT THE WRITER
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.
Ā©2018 Jack Guttentag
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