Friday, February 10, 2012

Annuities and Delayed Social Security

Today I’d like to feature Joe Tomlinson’s February 7th column for Advisor Perspectives, “An Innovative Solution to Retirement Income.”
He looks at two strategies which deserve more attention than they get: single premium immediate annuities (SPIAs) and delaying Social Security until age 70.
Though you must give up control of your assets, he notes that the current quotes for inflation-adjusted SPIAs are $446.95 per month for a $100,000 payment. That works out to $5,363 per year. That means you are locking in a 5.36% inflation-adjusted withdrawal rate for life. You’ve got to compare that with the alternatives for a systematic withdrawal plan based on safe withdrawal rates research. There’s the 4% rule, but if you think that is optimistic, you may be thinking more in terms of 3% or 3.5%. In this case, it may really make sense to consider some partial annuitization (no one says you have to annuitize everything).
Annuities may sound too good to be true, but very simply the reason that they work is because the insurance company can pay you assuming that you will live to your life expectancy. That is because they can average the uncertain lifetimes of individuals across a very large group of customers. Sorry for the crassness of this sentence, but those who die sooner end up subsidizing those who live longer. If you are planning only for yourself (and/or spouse), you sort of need to assume that you will live quite a bit longer than your life expectancy (you have a 50% chance of living longer than your life expectancy) in order to make sure you don’t run out of funds. That means you should be withdrawing less than possible if you knew exactly when the end would come. The insurance company can take advantage of these averages (their average customer will live to the expectancy, at least after making adjustments for the fact that there is some self-selection so that annuity buyers end up living longer than the general population) to be able to pay you more.
About the issue of whether it is a good idea to buy annuities when interest rates are low, I did make a figure which I hope can contribute something. I wrote a program to calculate annuity payouts. Insurance companies certainly use more sophisticated mortality data than me (I’m just using Social Security mortality data) and they also have more complicated ways to deal with investment returns (I just assume an interest rate) and that may mean the level of the line in this figure is not right. Perhaps it should be shifted up or down.  But I do think the slope is basically okay. And so it shows you how the annuity payout relates to the interest rate.  Again, these numbers may not be super accurate, so while I show that a 0% interest rate has an annuity payout of 5% and a 4% interest rate has an annuity payout of 7%, what is important is that the payout of an annuity is 40% higher when the interest rate is 4% than when it is 0%.  I think this can give some idea about the tradeoffs with buying an annuity now or with waiting (and hoping) that interest rates increase before buying an annuity:

Actually, I made that figure while on a business trip to Boston in October. I saved the figure then, but later I had some computer problems and lost the computer code for making it. So I can't remember all the assumptions I used in that figure.  I think it is an inflation adjusted annuity, perhaps for a 65 year old male.  There might be an overhead cost built in. But I'm not sure.  This is something I will come back to again with more clear explanations at some future time once I re-program it.
Meanwhile, the other important issue Joe discusses is the financial benefits from delaying Social Security. It reminds me of a chart I made once for an article, but never ended up using. This was based on a large sample of Social Security recipients in 2004. For these recipients of retirement benefits, I looked at everyone’s initial age for benefit receipt. The distribution looked like this:

Half of the recipients began at the earliest possible age of 62. Only about 3% of recipients began at age 66 or higher.  Joe explains why it makes a lot of financial sense to delay receipt to age 70.  It’s a great deal, the best inflation-adjusted annuity that money can buy. Yet people just don’t seem to be willing to do it.
Finally, he also discusses an innovative plan that would call for the government to make inflation-adjusted annuities available through Social Security offices.
Definitely have a look at his column for more about these helpful strategies.
If you are interested in annuities, Bob Seawright also recently wrote a very good column called “The Annuity Puzzle” for Research magazine. Mike Piper at the Oblivious Investor also wrote a good column about annuities in low-interest rate environments. Also make sure to read the set of comments started off with a good point made by Matthew Amster-Burton about how annuities could be even more attractive in low interest rate environments.
Finally, I was part of a student fieldtrip to Kyoto when it happened and then forgot to mention it, but I would like to thank the Finance Buff for making my blog into his “blog of the week” last week. As I owned a copy of his highly worthwhile book, Explore TIPS, before I knew about his online presence, it is a nice honor for me.