Money’s Worth Measures For Income Annuities
This article appears at the following website: forbes.com
Annuities have a reputation for being a high-fee financial product. Is this reputation deserved? We address this for different types of annuities throughout the book, starting with income annuities. It is a bit complicated to answer this for income annuities because they do not have visible fees. There are no additional fees extracted from the quoted payout rate, as the payout rate is a net number after fees have been deducted internally. Simply, with the internal fees, the quoted payout rate is lower than it could have otherwise been.
Fortunately, we can reverse engineer the fair price for an income annuity without fees and then compare it with real-world annuity payout rates in order to obtain a money’s worth measure for the income annuity. We have already seen how to calculate annuity prices. The additional complication relates to making reasonable assumptions for interest rates and mortality rates.
It can be difficult for consumers to get a handle on the sorts of fees and costs that are paid as part of purchasing an income annuity. Some states may place a small tax (ranging from 0.5 percent to 3 percent) on annuity premiums taken from outside retirement plans, but annuity costs are otherwise incorporated into the quoted prices and not explicitly charged from the premium.
Costs are not transparent. For example, a $100,000 premium may be quoted as supporting $600 per month for life. Without any built-in fees, perhaps the fair monthly income could have been $610 or $620. At the same time, perhaps the household could not invest for as much yield as the insurance company or might have an unusually long expected lifespan, such that a more personalized fair monthly income is only $580 or $590. In this case, the annuity provides a great deal. These matters are not transparent unless we are able to calculate the actuarially fair price for an annuity and then compare it to the actual price.
Fortunately, this reverse engineering process lets one estimate the costs built into an income annuity. If an income annuity provides $600 per month, but we simulate that a fair price is to provide $610 per month, then the money’s worth of the annuity is $600 / $610 = 0.9836. In this case, the commercial annuity pays 1.64 percent less than the fair price. We could interpret this 1.64 percent as an upfront transaction cost or onetime fee for purchasing the annuity.
For a more practical real-world example of this, in January 2019, the actual payout rate on a life-only immediate annuity for a sixty-five-year-old female as described in Exhibit 4.1 is 6.52 percent, according to ImmediateAnnuities.com. The payout rate we calculated is 5.78 percent. If our interest rate and mortality assumptions properly reflected the prospects facing the insurance company when making their pricing decision, then this income annuity appears to be a great deal. The actual payout rate of 6.52 percent divided by our estimated payout rate of 5.78 percent is 1.128. We actually get 12.8 percent more income from the commercial annuity than we expected to be able to receive as based on our assumptions. To calibrate the actual payout rate with our mortality data, a flat yield curve of 4.15 percent is needed, instead of the 3 percent used in that exhibit.
We had heard about annuities and were investigating them for our IRAs. We also heard bad things about pushy brokers over the years. So when we went to the ImmediateAnnuities.com site we were skeptical about calling them. But whenever we called their staff was really friendly. They answered all our questions and one of their reps even told us that at our ages there was no advantage to buying the annuity with our IRAs. These guys are really honest!
Separate from the objective money’s worth measure, it is important to also consider the subjective value being received by the annuity owner. For those with longevity risk aversion, the prospects of spending from investments may be such that an income annuity could still support more spending than the retiree otherwise would be comfortable taking from investments. Just because money’s worth measures are less than one does not necessarily mean that income annuities are a bad deal.
If retirees value the certainty provided by guaranteed lifetime income, they may value income annuities at more than their fair price. The income annuity provides risk pooling and mortality credits that an individual cannot create on their own. Conservative retirees who are worried about outliving their money and timid about investing aggressively in the stock market could easily decide that they are willing to pay more than the estimated costs derived from these money’s worth measures. Because of the certainty of income provided, I might still derive benefit even if the money’s worth measure was only 0.7, for instance. If so, then an actual money’s worth measure of 0.85, for instance, would be still be attractive.
The general account of the insurance company also has the potential to invest for higher rates while still maintaining a high degree of safety in ways that may not be accessible to the household. We must consider three issues: how much does the retiree value mortality credits, could the retiree earn a 4.15 percent return from their own investments with the same risk level as the annuity, and how does the retiree’s personal views about longevity compare with that of the overall risk pool?
Purchasing income annuities can be a win-win situation both for the consumer and the insurance company, as the benefits created through risk pooling are shared between both parties in the transaction. This is the same idea as how one may derive value from owning a mutual fund even after paying the expense ratio because it would not be possible to create such diversification with limited household assets.
More generally, what I have just described is true for any consumer good or service. If a producer can provide the good or service for more cheaply than I could achieve when trying to create it on my own, while still being able to generate a profit through their specialization and economies of scale that I do not have access to, but for a lower price than I value it, then I could derive a net benefit. The transaction is mutually beneficial for both parties. It is important not to forget this fundamental axiom of capitalism applies for insurance as well.
The previous sections explained how to calculate the price for an income annuity. To do a proper money’s worth calculation, though, we must be more detailed and specific about the appropriate assumptions to make regarding interest rates and mortality data. What longevity data is most relevant to the annuity owner? How could the owner have invested the premium while maintaining a similar level of market risk if left to his or her own devices? The answers are not clear cut.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.