OK, so it’s not exactly “fun.” But a new report says retirees who convert their savings into guaranteed lifetime annuities effectively double the amount they are willing to spend each year, on themselves and their families.
The reassurance that they won’t outlive their savings lets them open up their wallets and have a good time while they can, argue researchers David Blanchett and Michael Finke. Blanchett is the head of retirement research at QMA/Prudential Financial, an insurance company, and Finke is a professor and chair of economic security research at the American College of Financial Services.
What a pity annuity rates have collapsed with bond yields, leaving retirees with even fewer sound options than they used to have.
“We find strong evidence that households holding more of their wealth in guaranteed income spend significantly more each year than retirees who hold a greater share of their wealth in investments,” they write. “Marginal estimates suggest that investment assets generate about half of the amount of additional spending as an equal amount of wealth held in guaranteed income. In other words, retirees will spend twice as much each year in retirement if they shift investment assets into guaranteed income wealth.”
They reach this conclusion by studying the investments, and behavior, of 725 households in the University of Michigan’s long-running Health and Retirement Study. They looked at retired households with more than $100,000 in savings and spending more than $25,000 a year.
Effectively they were comparing the spending habits of those with a guaranteed income of, say, $50,000 a year and those with a pile of savings big enough to buy a lifetime annuity from an insurance company that would pay them a guaranteed income of $50,000 a year.
It’s a big finding to balance on top of a reasonably narrow base. But even if the effect of owning an annuity isn’t as big as they estimate, the findings are surely ‘directionally correct,’ as consultants like to say.
Lifetime annuities like this, known in the industry as “single premium immediate annuities,” are effectively an insurance product that protect you against the peril of outliving your money. Those who die young end up subsidizing the incomes of those who live a long time.
They make great sense in theory.
Without them, you’re left trying to work out what return you’re going to earn on your investments, how volatile they will be, how long you will live and how much you can spend. An especially big concern is late life medical expenses, including nursing home costs.
The result, report multiple studies, is that middle-class retirees end up playing too much defense. They typically spend well below their income. Instead of using their lifetime savings to enjoy their senior years, they end up trying to protect their money.
Yet studies have shown that the typical middle-class retiree holds far less of their money in annuities than you’d expect.
When you eliminate Social Security, the biggest lifetime annuity by far, it’s even less.
Financial experts have spent decades grappling with this apparent ‘puzzle.’ (Of course the insurance industry has an enormous incentive to sell more of these products. But that doesn’t mean they’re wrong.)
Why, they ask, don’t retirees buy more annuities?
Some blame psychology. Others say annuities are too complicated for many investors to understand. Others point out that about a third of retirees want to leave an inheritance behind them.
But of course there may be another reason. They may simply be worried about inflation. That’s because inflation is the one thing that will devastate your annuity income. The typical annuity pays a fixed income each year for life. The payout doesn’t change. So your annual spending power goes down each year by the rate of inflation. Those living on fixed incomes in the 1960s and 1970s, when inflation got out of control, got completely hosed. And once you’ve put your money into one of these annuities you can’t get it out again.
We’ve already seen how the current official inflation figures are apparently grossly undercounting housing inflation.
You can get annuities with annual cost of living adjustments, but those adjustments are typically capped at around 3% a year. And such annuities are much more expensive than the regular kind—reflected in even lower starting payouts.
For example, a 65-year-old woman with $100,000 could buy a fixed income annuity that paid her about $470 a month for the rest of her life. That’s according to the latest issue of Annuity Shopper, the industry guide. But if she went for an equivalent annuity that contained an annual cost of living adjustment, she’d be lucky to get a starting payout of $330 a month—a third less.
Annuities make a ton of sense for retirees, but right now the payout ratios across the whole industry, alas, are terrible. A new 65-year old retiree buying a single premium immediate annuity today can expect to get a monthly income that’s a third less than it was at the start of the millennium. It’s even down 20% in the past decade.
Annuity payout ratios are based on corporate bond yields — because the insurance companies invest the premiums in safe bonds. So the collapse in bond yields over two generations has slashed payout rates.
If inflation rears its head again, future annuity shoppers will presumably see the benefit in higher payouts on new policies. Higher inflation will mean higher bond yields, and higher payouts.
But those buying annuities today won’t see the benefit. On the contrary, they’ll find they’ve locked in today’s low payout rates while also suffering future inflation. This is not to say inflation is coming, only that it’s a risk. At the moment it’s hard to see how annuity buyers, along with bondholders, are being fully compensated for that risk.
There are some sensible strategies often recommended by financial advisers that help mitigate the problem. One is to, yes, “diversify” your retirement account by buying an annuity with some of your money while leaving the rest invested in assets likely to earn a return. Another (related) idea to use some of your money to buy a delayed annuity that doesn’t kick in until you’re, say, 80. At that point you’re really just buying insurance in case you live longer. Because many people aren’t lucky enough to make it that long, insurance companies can afford to pay out more to those who do.
As an illustration, a 65-year old man spending $100,000 to start immediately would get a monthly income of less than $500. But if he spends that money on an annuity that doesn’t kick in till he’s 80, he’ll get $1,600 a month—if he makes it.
And the one slam-dunk way of getting a bigger inflation-adjusted monthly payout? Delay the day for as long as possible when you start taking Social Security.