Tuesday, March 19, 2013

Everybody Hates Annuities

Everybody hates life annuities except economists, but economists love them.

Most people don’t like the idea of handing a big chunk of their savings to an insurance company in exchange for the promise of a lifetime of monthly payments when that lifetime could end right after they sign the contract.

A client and his wife asked me for retirement advice a few years ago. I barely got out, “Hello. . .” when the wife said, “And don’t tell us about annuities. My sister bought one and died two years later.”

It was clear that would be the end of any discussions regarding life annuities. A lot of people feel that way.

Economists, on the other hand, don’t seem to understand how anyone in their right mind could pass up the opportunity to insure that they won’t die broke if they live to a ripe old age.

I am fully in the camp of economists when it comes to retirement planning, the alternative to be in the camp of those who sell stocks for a living. On this one topic, however, I part ways with most economists. I don’t like life annuities, but not for the reasons most people say they dislike them.

You can get around the problem experienced by my client’s sister by purchasing an annuity contract that promises to return your investment in the event of an early death. Still, life annuities are a tough sell. You lose control of your capital with a contract that is difficult to understand and harder to undo.

But there are two other problems with life annuities that bother me more. First, you can’t know how much a life annuity will cost until the time comes to purchase one. Their prices are largely determined by your age at the time of purchase and interest rates at the time of purchase.

“I’m about to retire,” a client recently told me. “Should I go ahead and buy a life annuity now?”

“Probably not,” I explained.

You see, the thing about immediate annuities is their immediacy. 

My client wanted to buy an annuity today that would begin paying out a pre-determined income in fifteen or twenty years. We’d all like to buy one of those, but no one will guarantee you payments today to begin several years from now because they don’t know what interest rates will be then or how much inflation we’ll experience. If you buy an immediate fixed “life” annuity today, you must begin receiving payments in less than a year.

My client wants to retire in his late fifties and a life annuity beginning at that relatively young age would be extremely expensive, plus it would lock in today's low interest rates. That’s a terrible time to buy.

The younger you are when you purchase a life annuity, the more the annuity will cost because the insurance company will probably have to pay you for a longer time. It "costs more" in the sense that it pays out less for the same contract amount.

With immediate fixed annuities, you more or less have to keep shopping for one until it "goes on sale", meaning you're probably around 70 years old and long term interest rates are sufficiently high. That makes life annuities a very difficult tool for planning.

How much difference can interest rates make? Several years ago, I priced out an annuity that would pay $1,000 a month for the rest of my life beginning at age 65 and $500 per month to my wife if she survived me. At that time, had I been 65, I could have purchased the annuity for about $113,000.

Recently, in this time of extremely low interest rates, I priced the same annuity and was quoted a price of $240,000.

Let me express that another way. Several years ago, $1 per year of income beginning at age 65 and paid for however long I might live with the 50% survivor’s payout would have cost me $9.42. Today, that same $1 per year of income would cost me about $20.00.

The cost of a lifetime annuity, like the price of bonds, moves opposite interest rates. If interest rates go up, life annuities pay more (they’re cheaper) and vice versa. That’s because insurance companies use bond interest they earn to make annuity payments.

The same is true of alternative investments, of course. When interest rates are low (as they are now), it isn't a good time to buy bonds for future income, either. There just isn't a good way to purchase retirement income when rates are low. You need to wait. And that means being reactive instead of planning.

Interest rates are unpredictable and they can make a huge difference in the cost of an annuity, so I can’t plan my retirement finances or yours using life annuities. If you ask me how much monthly income you can receive if you use your retirement savings to purchase a life annuity, I can’t tell you unless you plan to purchase it pretty soon.

The second problem I have with life annuities is inflation. Most life annuities pay income in nominal (inflated) dollars. A few companies offer contracts with inflation protection, but it is extremely expensive. You should expect it to be, because guaranteeing inflation rates for thirty years or more is very risky and you’re paying the insurance company to transfer that risk from you to them.

The ideal retirement income investment would generate a steady, predictable income from the day we retire until the day we die, even if that turns out to be 40 years, and it would be affordable. At first glance, a life annuity seems to do that, assuming interest rates are high enough at the time you purchase the annuity for it to be considered “affordable”. Here’s what income looks like for a nominal annuity, i.e., one without inflation protection:

(Click on any of these graphs to enlarge them.)

How bad can inflation be over thirty years? Pretty bad, as it turns out. The following chart shows what would have happened to the purchasing power of $1.00 over 67 rolling thirty-year periods beginning with 1915-1944 and ending with 1981-2010.

In the best case (1921-1950), $1.00 still bought $0.75 worth of goods after thirty years. That’s the top line at the far right of the graph and it averages just less than 1% inflation per year. But in the worst case (1968-1997), it bought only $0.18 worth of goods after 30 years of inflation averaging 5.6% per year. (The lowest line on the right side of the graph.)
The thick, red line shows the median value of $1 for each of the thirty years across all periods. The median nominal $1 was worth about $.32 after thirty years. Those lines that go above a dollar on the chart, like the blue one I pointed out, are a result of deflation in the 1920’s and 1930’s. If you believe that deflation is unlikely to repeat and you begin the chart in 1940, then the median nominal dollar falls to $.26 over thirty years.

These are the real dollar outcomes you would have received from a nominal annuity. I’ll add a thick blue line, just for emphasis, to remind you what retirement income we “desire”, which is also the payout pattern of a nominal annuity. You can compare our desired-income/nominal-annuity-income to the real income we would have historically received.

The gray lines indicate the best and worst inflation, so I can remove the historical data in between and simplify the graph.

The red line doesn’t seem to be what we’re looking for, does it?

When you consider real dollars (in red) as opposed to inflated dollars from a nominal annuity (in blue) — and that should be the real consideration for a retiree — nominal annuities are a poor fit to the ideal investment I charted in the first graph.

As I mentioned, inflation-protected life annuities can be purchased, though they aren’t cheap. I recently priced a life annuity for a 65-year old male with no inflation protection and another with inflation protection. The payout for the former was 5.84%, meaning it would pay $5.84 (nominal) for every $100 of annuity I purchased. The latter would pay just $3.88, but that amount would be adjusted to compensate for inflation over time.

Said differently, I could receive $1.00 of income in year one, whose purchasing power would decline with inflation through the years, or I could receive $0.66 of income in year one for the same price and its purchasing power would remain constant throughout the remainder of my life.

Now, let’s add the purchasing power of that inflation-protected life annuity to the chart above. The thick black line represents the inflation-protected (real dollar) income I could purchase for the same price as a nominal annuity based on those two recent quotes.

What does this chart tell us? First, the inflation-protected annuity income (black) matches our “desired income” (blue) distribution pattern, but not its value. It’s 33% less to begin with. After about 10 years, though, it comes closer to what we desire than the nominal annuity does.

Second, inflation protection is expensive. In the median historical case, it took about 10 years for the inflation-protected annuity to catch up with the nominal annuity. But, if those were my only two choices, I would still purchase inflation protection.

Why? Because I would buy an annuity as insurance against running out of purchasing power in the event that I live a long time.  A nominal annuity doesn’t usually provide that insurance after 15 or 20 years nearly as well as an inflation-protected annuity.  The nominal annuity is a lot cheaper, but I don’t go to the hardware store needing a shovel and buy a rake, instead, because it’s cheaper.

Besides, if I thought I would only live ten years or less, I wouldn’t purchase any kind of annuity. Live longer than 20 years and the inflation-protected annuity always wins.

Life annuities without inflation protection do a very poor job at exactly what we want them to do — provide purchasing power if we live a long life. In fact, the median nominal annuity pays about 60% of its purchasing power in the first 15 years and only 40% in the last 15 years, the period you are trying to insure.

An inflation-protected annuity is better than a poke in the eye with a sharp stick, but these aren’t my only choices and I still don’t like annuities.

Friday, March 8, 2013

But What If You Do?

People nearing retirement age often tell me that they plan to claim their Social Security benefits at the earliest possible age of 62. More often than not they’ll explain that they would have to live 15 years or so, to age 77 or 78 depending on individual circumstances, to come out ahead. Someone told them that is their "break-even age" for Social Security retirement benefits.

They go on to explain that they don’t expect to live that long, though for the life of me I can’t figure out how a reasonably healthy person would know how long he or she will live, or why they would be willing to bet a lot of money on it.

At a baseball game last summer, one of my buddies looked around and asked, "What's the break-even age for Social Security benefits?"

A partner from a CPA firm answered, "Around 78-80 depending on your specific situation."

"Huh!" he grunted, turning back to the game. "I'm not gonna live to 80."

So I asked him, “But what if you do?”

Consider Fred and Ethel, a married couple in their 60’s. Fred would be eligible for Social Security benefits of $1,735 monthly if he received them at age 62, or $2,300 if he waited until age 66. If he could postpone receiving benefits until age 70, he would receive $3,030 a month for the rest of his life, a whopping 75% more than if he claimed at the earliest age.

Fred plans to claim at age 62 because he thinks he won’t live a long life. He’ll come out ahead in lifetime benefits if he claims early and doesn’t live past age 78 or so.

But what if he does?

The following chart shows Fred's total lifetime payments from Social Security retirement benefits if he lives to various ages and claims either at age 62, 66 or 70. For example, if he claims at age 62 and dies at age 76, he will receive payments totaling about $312,000 over 14 years. Should he claim at age 66 and die at 76, he would receive about $304,000.

To simplify the chart, let's divide it into three sections, or three possible future scenarios for Fred.

First, look at the middle section when Fred is around his break-even age of 78. If he dies within a few years either side of age 78, all three claiming ages work out about the same for him, so his benefit-claiming age decision wouldn't have a big impact either way.

Next, let's look at the early retirement years preceding the middle section. In these years, Fred will either have a short-term and urgent need for his benefits because he has limited income and savings, or he will have the option to transfer some early retirement standard of living to late retirement. He would do this by postponing his claiming age. That would give him less income in early retirement and more in late retirement, should he live that long.

Regardless, if Fred doesn't live past early retirement he is clearly better off claiming early, but his spouse may not be. Ethel's survivors benefits will be 100% of Fred's retirement benefit at death.1 If she survives Fred, she will live the rest of her life with the lower benefit that Fred chose for her by claiming his own retirement benefits early.

If Fred lives just a few years after retiring he will receive more total benefits if he claims early, but the opposite is true if he lives a long life. So, which should he bet on?

A short retirement is relatively less expensive than a long one, and often a lot less expensive. A short retirement requires less savings. It may be possible to return to work if you run low on funds early in retirement.

A long retirement is far worse from a financial perspective. It costs a lot more. You're too old to go back to work. You've probably depleted most or all of your savings. You'll need some of that early retirement standard of living more in your old age than you needed it in early retirement.

Running out of money in late retirement is the worst-case scenario and a good financial planner would insist on taking the worst-case scenario off the table.

So, Fred believes that he and Ethel won't live a long life, but what if they do?

They would be much worse off claiming benefits early and living a long time than claiming later and living an average lifetime or less.
Break-even ages would be interesting if they showed that you would have to live to 105 to break even (everyone would claim early), or if you only had to live to 64 (everyone would wait), but they don’t. They show that you must live to an age that you might reasonably expect to attain and that you might not. 

Consequently, I find break-even ages relatively useless.

How about investing your retirement savings in the stock market?

The “4% Rule” strategy for investing retirement savings in stocks says we have a 95% chance of not outliving our savings. That’s great if you don’t end up in the 5% group of retirees who go broke, but what if you do?

Those web-based retirement calculators show you what will probably happen to most people. They don't show what might happen to you.

Anticipating the worst-case financial outcomes and planning to avoid them, even at some cost of our retirement standard of living, is what we call risk management. Break-even analysis isn’t risk management, nor is betting on future stock market returns. It’s betting that everything will work out fine. It’s playing the odds that we (and our spouses) won’t live longer than an average lifetime, that inflation won’t run away, and that the stock market gods will smile on us.

Perhaps you and your spouse won't live longer than average lives. Maybe inflation will remain below 3%. Maybe you won't experience a long-term bear market after you retire.

But what if you do?

1 Assuming Fred has begun receiving those benefits, otherwise it will equal 100% of his retirement benefit at full retirement age.