By: Frank Armstrong
The Treasury Department thinks Americans should consider annuities. Me, not so much.
We have a problem. Too many retirees are outliving their retirement accounts. Treasury thinks they are living too long. So, they are encouraging retirees to purchase longevity insurance (deferred annuities) inside their IRAs.
I think they don’t have enough money when they retire. They didn’t save enough or invest wisely while they were working. Longevity insurance isn’t going to solve that problem.
Here’s the Deal
Under Treasury’s new guidelines you can now direct 25% up to $125,000 of your retirement account into the purchase of an annuity which pays nothing until you are 80 or 85. After you begin annuity payments at the date selected, you receive a lifetime income. Any amounts that you allocate to the longevity insurance will be excluded from the Minimum Required Distribution (RMD) rules.
Insurance companies are jumping all over this. At first blush, it sounds compelling. For instance, if I’m 65 I can plunk down $125,000 to purchase an annuity from a name brand major company that promises to pay me $79,987.50 for life if I live to 85.
Wow, that sounds great! The problem is that there is a very good chance I won’t make it to 85, and then I get nothing. The basic concept here is that a ton of participants are going to die before they get a penny. Those that do make it are not going to get paid for very long before they die and forfeit their contribution to fatten up the payments to the fewer lucky survivors. Each participant is making a huge bet against his peers and on himself. If this were a horse race this would be called a longshot.
It’s hard to know how I might feel after I’m dead, but I can’t imagine being too happy about blowing $125,000 and getting nothing back. It’s going to be little consolation to me to know that my neighbor is sipping bubbly and stuffing himself with caviar. In the industry this is known as the “hit by the bus” problem and is one reason why whether it’s rational or not, most people won’t buy annuities.
As an option, I can take a much smaller income at age 85 and if I don’t make it long enough to cover my costs then my heirs get the balance of my unrecovered premium payment back. So, by solving the hit by a bus problem we greatly restrict future income.
There is also an inflation risk. If inflation were to jump to 6% then at the end of the 20 year period the real value of the fixed income would be cut by three quarters of the nominal contract value. And if you want some level of inflation protection in your annuity, the based amount at age 85 will be even less. Remember, all these adjustments are cumulative.
Lost Income During Early Retirement
If I haven’t got enough money in the first place, forking over 25% of my capital isn’t going to do me much good in the next 20 years. Suppose I had a lump sum of $500,000 at retirement in my 401(k). At conservative withdrawal rates of 4% to 5% per year I could reasonably expect to withdraw $20,000 to $25,000 a year forever and anticipate some inflation protection.
But, by spending $125,000 today, I’m giving up $5000 to $6250 a year assuming the same 4% to 5% sustainable withdrawal rate. So, I’m taking a 25% haircut off my retirement income from my lump sum. That’s a pretty big lifestyle change for someone with an already limited income.
Once the funds are committed to the tender mercies of the insurance company, it’s locked up. If I really need some money for an emergency, they will politely tell me to kiss off.
If I try to make up for lost income by higher withdrawal rates I increase dramatically the chance that I will run out of money before age 85. So, if I were to go broke at age 79, what would I do to console myself until I got the big payout at 85? Suppose I then die at age 84?
If I’m healthy as a horse and all my ancestors and siblings lived to 105 this might be an OK bet. But, bad family history and/or a few health problems of my own stacks the deck heavily against me.
Historically Low Annuity Purchase Rates
Today interest rates are at historical lows, so annuity purchase rates are also dismal. But, if interest rates rise, a person buying today will not benefit. The insurance company has you locked in and any improvement in annuity purchase rates will only be available to future buyers.
The Central Problem: Not Enough Capital
The overarching problem is that retirees don’t have enough capital to support themselves for a 30 some year projected life expectancy. They haven’t saved enough and/or invested it wisely while they were working. So, they don’t have any good choices. Annuities in any form are unlikely to solve that problem.
A related problem is that many retirees exceed sustainable withdrawal rates on their available capital so that inevitably they run through their nest egg. Here, perhaps annuities can help those that cannot muster the discipline to keep their spending habits in check.
You might have noticed that my enthusiasm for annuities of any type is restrained. But, to be completely fair it’s unlikely that any other guaranteed income stream can match an annuity. That’s because people dying early contribute their capital to support those that live a long time. And only an insurance company can guarantee you an income for life. The tradeoff is no inflation protection, no growth of capital, no access to your capital no matter how dire your emergency, confiscation of your capital at death, and the certain knowledge that if you die early you have made a very bad choice.