Is an Annuity Worth More When Interest Rates Are Low?
Most of us think annuities were a much better deal when interest rates were a lot higher, as for example in the 1980s. But Professor Alicia Munnell of the Boston College School of Management thinks otherwise.
Prof. Munnell says an annuity is really worth more during times of lower interest rates. In this article we explore why Prof. Munnell favors annuities, and we look at two alternatives to annuities for generating retirement income.
It's no secret that, on average, you are likely to live longer nowadays than your parents did. With increasing life expectancies, today’s retirees need their income to last for many more years than was true until now.
Unfortunately, for the better part of this decade we have also faced historically low interest rates, which makes relying solely on interest to cover your expenses difficult at best.
It wasn’t so long ago when you could invest $100,000 in a high-quality Treasury Note and be confident about preserving the safety of your investment while at the same time earning a relatively decent rate of return.
In 2000, if you invested $100,000 in a 10-Year Note you would have received close to $6,000 in interest that year. But unfortunately, nowadays $100,000 invested in that same Treasury Note would only eek out about $1,500 in interest over an entire year!
So, for better or for worse, how can owning an annuity factor into your retirement income dilemma?
Prof. Munnell, has spent years researching this very question. Before joining Boston College, she was a member of the President’s Council of Economic Advisers (1995-1997). Before that, she spent 20 years at the Federal Reserve Bank of Boston (1973-1993), where she became senior vice president and director of research.
Prof. Munnell explains there are three main approaches most retirees take to securing a lifetime of income from their assets.
1. Self-Annuitization Strategy (The DIY Annuity Solution)
According to Prof. Munnell, one option for creating retirement income is to "self-annuitize." This does not involve an insurance company. To self-annuitize from your investment portfolio you take a certain percentage out each year while leaving the remainder invested to grow over time.
Prof. Munnell gives the following example. Say a 65 year old retiree with $100,000 withdraws $5,048 each year. Why $5,048? Because that is the amount of income this retiree would receive from a lifetime annuity if he bought one toady (August 2016) from a top-rated insurance company. This retiree would have enough income from his portfolio withdrawals for a considerable period of time. But for how long?
Given continued stock market volatility and historically low interest rates, Prof. Munnell found that the portfolio would be depleted when the retiree reached age 83 (after 18 years), yet he still had a 54% chance of living past age 83!
In other words, self-annuitization may not be a viable option for most retirees given today's longer life spans. With self-annuitization, you always run the risk of running out of money before you “run out of time.”
2. Long-Life Strategy (Tweaking Your Withdrawals)
Prof. Munnell correctly observed that self-annuitization cannot guarantee you an income stream for life if you have the good fortune of living too long. But couldn’t a retiree opt for a so-called long-life strategy where he take into consideration living to an older age and therefore reduces the monthly withdrawal amount over time to have enough income for the long haul?
Prof. Munnell found the longer the horizon you plan for the less retirement income you will have to spend on an annual basis given a certain amount of invested principal. So, if you figured on living long, your annual income would also drop substantially from $5,048 to only $2,857 per year by age 100 - and that would still leave open the question of what to do in the unlikely event you live past age 100.
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3. Buying an Immediate Annuity
According to Prof. Munnell’s calculations, the gains from buying an insurance company annuity can be significant - even when interest rates are in the lower ranges. This is due in large part to what actuaries refer to as “mortality credits.” These are essentially the excess payments that are left behind when other immediate annuity owners invested with your insurance company pass away.
Mortality credits are a component of immediate annuities that do not exist in other financial vehicles - and because of this, they allow an immediate annuity to pay out guaranteed lifetime income streams to those who end up living the longest lifetimes.
Although nobody knows for sure how long they will actually live, insurance companies know that a given percentage of their annuity buyers in the overall pool will live a long time. Because insurers pool their funds, an annuity can pay out a portion of the funds that are left behind by those who have passed away.
This essentially provides a larger amount of guaranteed lifetime income payments for those who are still living - and more than any one single individual could have likely provided for himself or herself on their own. And yes, this is guaranteed income regardless of how low interest rates go.
In fact, based on Prof. Munnell's findings, a comparison of the alternative options shows that the gains from insurance company annuitization are substantial, even assuming that interest rates are at 0%.
The Bottom Line
So, while there may be other ways that a retiree can configure his income streams in order to obtain a higher annual amount, there can also be a fair amount of risk involved - primarily a race with the clock.
For those retirees who are seeking an ongoing, predictable income stream, along with a solution for an unknown time horizon - regardless of the interest rate environment - an immediate annuity may just be the right answer.