Monday, February 3, 2014

Untangling Retirement Strategies: Life Annuities

In my previous blog post, Unraveling Retirement Strategies: Systematic Withdrawals, I set up a structure for comparing the various retirement funding strategies using eight criteria: primary advocates of the strategy, spending plan, investment strategy, liability-matching, longevity risk, spending floor and upside potential for standard of living.

In this post, I'll talk about the least favorite strategy among consumers for funding retirement, purchasing a life annuity. Ironically, this is the strategy most favored by economists for retirees who don't have a “bequest motive”, in other words, retirees who don't care if they have money left over after they die.

But consumers stay away from life annuities in droves, confusing economists to the point that they have dubbed the problem “the annuity puzzle”. A recent study entitled Optimal Annuitization with Stochastic Mortality Probabilities (try saying that three times real fast!), tries to solve the puzzle by suggesting what retirees know that economists don't that retirees may have health or other financial crises and need access to capital they might otherwise have used to purchase an annuity.


A life annuity is a contract with an insurance company to provide a set amount of annual (or monthly) income for as long as you live in exchange for a large payment in the case of a single premium immediate annuity, or years of smaller payments for a deferred annuity, up front. Unlike the other strategies I will describe, a life annuity is not something you invest in like a stock and it is not a loan, like a bond. It is an insurance policy that you purchase.

As with anything you purchase, the money you use to pay for it then belongs to the seller, the insurance company in this case. Depending on the options you might purchase, the insurance company has varying commitments to return any of that money even if you live only a short time after purchase and don't receive many payments.

Following is a diagram of potential spending from the life annuity strategy. It's a pretty boring chart except for one thing. The lines on the spending charts for other strategies move to the right until you run out of money. This one moves to the right for as long as you (and your spouse if it's a joint annuity) continue living. You never run out of money.
It is becoming typical for annuity contracts to return some of your purchase amount if you live ten years or less. Otherwise, the value of the contract is zero after the annuitant's death, or after the survivor's death if a joint annuity is purchased.

Purchasing a life annuity is the only one of the four major strategies in which the retiree loses control of his or her retirement savings. It is one of the two strategies that guarantee retirement income no matter how long you live and the only one to do that efficiently. You could, for example, set up a TIPS bond ladder that would secure income until you were 120 years old, but that would be a very inefficient use of your capital.

Insurance companies invest your money in bonds, so life annuities are not subject to stock market volatility. Life annuities create a secure floor of income. Because they are not invested in stocks, there is no upside opportunity to improve your standard of living.

Purchasing a life annuity does not provide liability matching. You have one source of consistent income from which to pay all future liabilities.

Some life annuities offer inflation protection at extra cost. Since your income is dependent upon the financial health of the insurance company, there is risk that company might not be able to meet its future commitments to make payments to you. However, this can be mitigated by only purchasing from highly rated insurers and by spreading your purchase across multiple insurers by buying multiple annuities. Furthermore, most states guarantee annuity policies against insurer failure up to $100,000 in many cases and up to $500,000 in New York. provides a summary of state coverages and the National Organization of Life and Health Insurance Guaranty Associations provides detailed information for each state. If you really want to get into the details, read The Annuity Advisor by Kitces and Olsen.

The cost of a life annuity generally depends on the annuitant's age, prevailing interest rates and health. (Life annuities are like reverse life insurance policies. Poor health generally means better rates with an annuity because the insurance company bets you won't live as long.) A good, low-cost source for life annuities is Income Solutions, available through Vanguard Investments.

A life annuity for a 65-year old couple with 100% survivor benefits recently paid out 5% of the purchase amount annually, or 3.8% annually with inflation protection based on the Urban Consumer Price Index (CPI-U). Note that these are not rates of return, but payout amounts that include return of your capital.

I'm not a huge fan of life annuities, although I can think of some situations for which they are perfect. I would recommend a life annuity for a dependent who simply can't manage money. Someone with a substance-abuse problem, for example. They won't be able to spend it all as soon they get it. They will always have a source of income. You could do this with a trust, but that gets really complicated.

The authors of the paper referenced above conclude that hardly anyone should annuitize and that many should do the opposite of annuitizing buy life insurance. Still, some retirees will be attracted to the concept of never running out of money no matter how long they live.

Based on life annuity sales numbers, however, there aren't a lot of them.

In my next post I'll describe the “floor-and-upside” strategy.


  1. It is a dismal science indeed that recommends that I hand over my accumulated savings to an insurance company. I would not presume that the Missouri legislature would allow that state to honor its "guarantee" -- in their wisdom they have de-funded education and supported increasing the number of potholes in proportion to the increasing number of corporate tax breaks. I'm looking forward to the remainder of your series. Thanks!

    1. I love a comment that makes me smile.

      Annuities??? Next!

  2. Why do you say that a life annuity is not liability matching. Although I'm not a big annuity fan, seems to me they meet your definition...Liability-matching is identifying current financial resources that will be used to pay for a future expected amount of spending.

    1. Annuities pay the same amount annually. Your annual expenses throughout retirement are likely to change (likely to decline over time). The amounts won't match.

      You can set up a bond ladder to match different amounts of liability expected for different years.

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