I’m stumbling into a growing cloud of confusion, one that’s creeping into the dialogue around life annuities and insurance products with guaranteed lifetime income. This fog is pervasive and thick within the neighborhood of rationales and reasons offered to retirees as to why they might want to include annuities in their aging portfolios.
Generally speaking these well-intentioned conversations center around the longevity risk that is associated with living an unexpectedly long time, or the financial cost of becoming a centenarian and the benefit of pooling resources with a large group of similar retirees. Indeed, if only one or two people from a starting group of 20 reach the age of 100, then if everyone collectively combines a portion of their financial portfolio to support the few who are lucky enough to beat the odds and reach advanced ages, it will be cheaper for the entire group, etc.
I have no quibbles with this line of reasoning and in fact have used most of these tropes myself. But to be clear and quickly get to the essence of this essay, there really are two different things going on within the life annuity story: credits and insurance. As an industry and as a community we must agree not to conflate them.
One aspect of the annuity story is the financial benefit of risk pooling, and the other is the insurance benefit and comfort from having a guaranteed income that you can’t outlive. Again, those are two quite distinct features. And, right now I’m growing in favour of the former (credits) over the latter (insurance.) This all might sound rather jumbled and theoretical, so allow me to elaborate with a statement that some readers might find shocking.
If you are 75 years-old with $100,000 in your retirement account and would like to guarantee a protected annual income for the rest of your life, there is absolutely no need to purchase a life annuity from an insurance company to achieve that goal. There are other options.
No, I haven’t lost my mind and joined the opposition. But yes, I can assure you that if you politely ask a non-insurance company investment-bank or your favourite broker-dealer for example, they can grab some inventory and design a lovely portfolio of zero-coupon strip bonds that will do the job. That collection of bonds will generate $4,000 per year for the rest of your life, even if you reach the grand old age of 115. Ok, BDs need to eat too, so they may not do it for $100,000, but I’m sure that a lump-sum of $1,000,000 will pique their interest and in exchange you will get $40,000 per year. Scale it up and they will come.
Moreover and with these strips, if you don’t make it all the way to the astonishing age of 115, they will continue to send those $4,000 (or $40K) to your spouse, children or favourite charity until the date you would have reached 115, if you had been alive. This collection of strips would be completely liquid, tradeable and fully reversable, although subject to the vagaries of bond market rates. For those readers who dream of numbers, I have assumed a conservative, safe and constant 2.5% discount rate across the entire yield curve, which isn’t entirely unreasonable in this environment. Think of the 30-year US treasury rate as a proxy, perhaps with a smidgen of corporate credit risk.
Stated technically, the present value of the $4,000 annual payments, for the 40 years between age your current 75 and your maximum age 115, is exactly equal to $100,000 when discounted at 2.5%. Yes, those numbers and ages were deliberately selected so my numerical example rhymes with the infamous 4% rule of retirement planning but has absolutely nothing to do with it.
Now, if you are still with me – and perhaps have been trained by a good annuity wholesaler – I’m sure you must be thinking (or even yelling) “Moshe, but what if you live beyond age 115, eh? You will run out of money!”
Touché. Let’s unpack that common knee-jerk reaction to a non-insurance solutions for a moment. To start with, the probability of becoming a supercentenarian – that is reaching age 110 — is ridiculously and unquantifiable low. There are only about 30 of them (verified) in the US, out of a population of 330,000,000. The chances of reaching age 115, remember that is when your strips run out, are even lower.
Right now the oldest living man in the world is Emilio Flores, who lives in Puerto Rico and is 112-years old. That’s three years short of the terminal strip. And, if do you happen to be the one in a 100 million (or perhaps billion) that reaches age 115, I suspect you will have other things on your murky mind. Personally and post-covid, there is a very long list of hazards that worries me more than beating Emilio’s record. Alas, some might argue that I’m neglecting medical breakthroughs and the risk we become a nation of Emilios. However, I’m more of a mortality compression-ist than extension-ist, which I’ll explain in another essay. In English, you won’t live to 115.
More importantly, nobody really “runs out of money” in retirement in the 21st century. That is plain utter fear mongering nonsense. With national social security programs in all developed countries, all Emilios will continue to receive some income for as long as they live even if they have completely emptied every piggy bank on their personal balance sheet. In fact, with tax-based means-testing you personally might get more benefits from your government if you actually do empty your bank accounts.
Ok, back to my prior claim and the supporting numbers, if you want a guaranteed (liquid, reversable, bequeathable) income for the rest of your life, you can exchange your $100,000 for a bunch of strip bonds and voila, you have a created a protected pension plan.
My point here is that the primary objective isn’t a guaranteed lifetime of income – which anyone can create with a simple discount brokerage account and a DIY instruction manual – rather, the goal is to get the HIGHEST possible income and at the LOWEST possible cost.
Here we go. Transferring the above-noted $100,000 into an insurance company sold income annuity would result in a guaranteed income of $9,000 per year, which is $5,000 more per year, even if they cut-you-off (and forget to send you further payments) at age 115. That more-than-double number assumes the insurance company uses the exact same 2.5% interest rate to price their products, which they don’t. In fact, if I do the same simple math with a valuation rate of 3.5% instead of 2.5%, the $100,000 would generate $10,000 per year at age 75, with the income annuity.
Back to my favourite investment-bank or broker-dealer, they would need to price strips at north of 8% to get me that sort of income, which they obviously can’t do unless the bonds are floated by some DDD country that will default well before I need dentures.
The reason for this rather magical jump to $9,000 from a mere $4,000 is that via the income annuity I have pooled my resources with many other similar 75 year-olds, but have given up the assets in the event of early-death in exchange for a subsidy to those living longer, etc. If you are willing to forfeit the money when the longevity coin falls on tails, then you can benefit from heads, etc. If you’re reading to this point, you know the drill.
To repeat, the motivation and rationale for the life annuity is *not* to necessarily generate a guaranteed lifetime income to some ridiculous age. Again, I can do that with simple discount bonds. Nor should the rationale be driven by the fear of running out of money in retirement. We don’t do that to people.
Rather, the legitimate concern retirees have is that their accustomed standard of living might be forcefully and involuntarily reduced if the markets don’t cooperate, and/or they live longer than anticipated. That can be mitigated by pooling resources and benefiting from mortality & longevity credits that accrue to those who are willing to share with their neighbours. Moreover, those credits will be more valuable in states-of-nature in which markets are performing poorly and the rest of my investments have taken a tumble. The implicit 8% return from a fixed-income product is the magic of longevity credits, a term I prefer over mortality credits.
This distinction between longevity credits versus longevity insurance opens the door for a universe of pooling products that don’t necessarily guarantee (or even offer) to pay income for the rest of your life, or guarantee anything for that matter. One can harvest mortality & longevity credits without requiring a rest-of-life horizon. For example, imagine a pooling arrangement that lasts for 25 or 30 years in which survivors inherit the investment assets of the deceased, thus acquiring mortality & longevity credits, but the entire fund is designed to be wound up when everyone reaches some predetermined age. Actuaries will recognize this as a temporary life annuity, temporary to age 115 that is. That fund might not promise longevity insurance per se, but it would certainly include generous longevity credits. I’m in and cue modern tontines…