INCOME ANNUITIES: Explaning and Measuring Return PART ONE

July 9, 2014 by Lowell Aronoff

An income annuity or a pension has some elements similar to an investment. Like a bond, you give an insurance company a sum of money in exchange for a regular check. The insurance product also provides an important benefit. Typically, the insurance company promises to pay you a guaranteed income for the rest of your life, no matter how long you live. This two-part article will try to quantify the value of an income annuity by comparing it to more common investment products and strategies.

To many consumers, an income annuity feels more like an investment product – like a bond or fixed income fund – because it provides them with a monthly check. Investment products are almost universally measured by their yield. It’s disingenuous to say that we cannot tell you what the yield is because we do not know how long you will live. This may be the truth but to the client it will feel evasive. We need a better way to explain this to clients.

In June 2014, a healthy 65-year-old woman with $100,000 could purchase an income annuity that includes a guaranteed payout for life, with 10-year period certain, that would pay the client about $525¹ per month. We do not know how long she will live, yet this information is needed to determine the final yield of her premium in an income annuity. We can, however, graph the client’s future yield against various ages when she may die, as shown below.

Clearly the longer the client lives, the higher her yield will be. When a client inquires about the yield from an income annuity, she is typically looking for a definitive number that she can compare to other investments. Although the client may not be interested in a graph, we can use statistics to delve deeper.

If we start with a large group of healthy 65-year-old women, we can say that, on average, they will live for 25 years.² This is known as the client’s life expectancy. If she lived to exactly age 90, the yield (net of commission and expenses) on her income annuity would be 4.03%. There are a couple of important things to point out with this number:

1. Very few clients live to their life expectancy. Remember that life expectancy is simply an average. In fact, there is more variability in a client’s longevity than in the S&P 500.³

2. While this is unlikely to be the yield the client receives, it is still a useful number to the insurance company that underwrites the income annuity because it is close to the average yield that they will pay. In other words, this yield is not useful for determining if the client made a good choice in purchasing the annuity. It is instead useful in determining if the insurance company that underwrites the investment is generating excessive profit.

This yield compares favorably to what a bond could provide for a similar level of security. But the question is not whether this is a good deal for the insurance company; the real question is whether this is a good decision for the client.

A key reason for purchasing the annuity is that the client may live longer and wants peace of mind in knowing that she will receive a paycheck until the day she dies. In other words, the insurance benefit – the guarantee to pay this client for the rest of her life – is very important. Since there is no significant difference between the yield that the client could receive from a bond fund consisting of underlying investments as secure as the general account of a highly rated insurance company, the insurance element of an annuity comes at no financial cost.

The client ‘pays’ for the insurance element in a different way. In exchange for a guarantee of a monthly check for life, the client agrees to keep this annuity for their life – no matter how long or short (beyond the 10-year guarantee). Some people will live longer than others and the income annuity is a vehicle that allows those with a shorter life span to subsidize the retirement income of those that will live longer. No one knows if they will outlive the average or not. The key point is that if the client lives longer than average, she increases her risk of depleting her income generating assets. An income annuity allows the client to transfer this risk to an insurance company.

While the yield at life expectancy is not a valid statistic to compare against other products because it eliminates the insurance aspect of the annuity, we can subtly rephrase the question to make it valid. If the client wants a guarantee of income for life, she will eventually need to consider purchasing an annuity. Should she buy an income annuity now or purchase a different product now in anticipation of buying the annuity at some future date when it is cheaper because she’s older? We can determine the answer to that by looking at a statistic called the Implied Longevity Yield or ILY™.

Most people have trouble planning for the rest of their lives, so let’s pick a seven-year horizon. A valid question might be whether the client should purchase an income annuity now (shown as Plan A). Or, would she be better off buying an alternative investment that pays the same monthly income for seven years and delay the annuity purchase until later when it will be cheaper (higher monthly income) because she will be seven years older (shown as Plan B)? Another way to express this question is: What yield would I need to earn from an alternative investment that would pay me the same monthly income as an annuity for the next seven years and leave me exactly enough money to purchase the same stream of income seven years from now?

While the math required to answer this question is not straightforward, a tool that provides the answer is readily available. In this case, the answer is that the client would need a guaranteed yield (net of commission and expenses) of 4.6% from a source that is as financially strong as an insurance company every year for the next seven years to justify waiting seven years to purchase an income annuity. In general, it is difficult for a 65-year-old to financially justify waiting to purchase an income annuity and the case for income annuities becomes more compelling as the client ages.

This is not to say that every 65-year-old should buy an income annuity immediately. Some clients are in no real danger of depleting their retirement assets because they spend less than three percent of these assets per year and they have an aversion to being locked into anything for the rest of their lives. Other clients might be sure that interest rates will rise soon. So, should they purchase an income annuity now?

In Part 2 of this article, we will examine the sensitivity of a purchase decision to future interest rates with a simple question: If the client believes that the yield curve will rise to its highest level in the next ten years, should she wait to buy an income annuity? We will then introduce a cost/benefit analysis to determine if the income annuity adds value to our client.

Originally Posted at NAFA Annuity Outlook on July 2014 by Lowell Aronoff.