Friday, January 4, 2013

Annuitizing Assets: Now or Later

Suppose you have already made the decision that you wish to annuitize part of your financial portfolio to buy a single-premium immediate annuity (SPIA). What factors should you consider when thinking about whether to buy a SPIA today, or to wait until a future date? Here is a first effort at developing what will hopefully eventually become a comprehensive list.

Factors in Favor of Waiting


 

By waiting, one has avoided the possibility of the unfortunate situation of having annuitized one's assets and then not surviving until the future date. One has also maintained flexibility and liquidity for their assets.
 

The payout rate increases with age, or conversely, it becomes cheaper to annuitize a desired income stream (assuming interest rates, aggregate mortality rates, and annuity provider business conditions stay the same). The payout rate increase is because remaining life expectancy falls, so mortality credits (which are amortized over time) are higher for new purchasers. Payout rate increases accelerate as one gets increasingly older and year-by-year mortality rates grow larger. This becomes quite important in one’s 70s.
 

At younger ages, it is easier for investment returns to exceed mortality credits, but risk must increasingly be taken to overcome the increasing return hurdle due to the growth of mortality credits with age.
 

Delaying avoids exposure to credit risk of annuity provider.
 

Factors in Favor of Buying Now

 

Buying now simplifies the retirement income planning process. One no longer has to worry about investment strategies, optimal withdrawal rates, or concerns about cognitive decline making it hard to develop good financial plans.
 

Even though the payout rate grows with age, you have less time to collect. Life expectancy is getting shorter, and that is the big reason why the payout is bigger. There really isn’t anything to be gained in that particular regard. When you wait, you still have to finance the retirement spending in the interim years.
 

Interest rate risk: If interest rates decline, annuity payout rates will fall making it more costly to obtain a given annuitized income stream. But fixed income portfolios may experience capital gains. If interest rates rise, annuity payout rates will rise, making it cheaper to guarantee an income stream, but fixed income portfolios may experience capital losses. Interest rate risk is experienced if the duration of fixed income assets does not match the duration of the annuity. Annuitizing now eliminates this risk.
 

Sequence of returns risk: Annuitizing reduces downside risk, but also reduces upside potential. If one waits, then another year is spent with systematic withdrawals from a portfolio. Poor market returns can reduce the value of the portfolio, which could result in less lifetime income when annuitizing later on.
 

If one invests conservatively like the annuity provider, there is less sequence of returns risk from market losses, but the decline in assets from portfolio withdrawals may nullify the increased payout rate from waiting. By waiting, one misses the mortality credits offered in the interim.
 

If interest rates are low, annuity payout rates are low, but also the yield from an investment portfolio and the sustainability of systematic withdrawals is low. There is ongoing debate about whether annuities are more attractive or less attractive when interest rates are low, relative to other available options. Conventional wisdom suggests that it is a terrible idea to annuitize assets when interest rates are low, but I’m not so sure.

17 comments:

  1. There are a lot of embedded assumptions here that are certainly true for some potential annuitants but not for all. For example, pointing out that "the sustainability of systematic withdrawals is low" seems to imply that the person is currently living off the income of the account that is to be annuitized. Also, some of the debits have the most force when the subject will annuitize just once instead of "laddering." I think it would be helpful if you made some of these points more explicit. One point you do not consider is the effect of inflation, although it's not obvious in what direction it cuts.

    ReplyDelete
    Replies

    1. Thanks, and I agree with all of your points.

      Delete
  2. When I think about annuitizing, I have focused on eliminating longevity risk. By allowing an insurance company to average my life expectancy with thousands of others versus drawing down an investment portfolio to ensure it lasts to my maximum mortality, it must require a smaller accumulation of assets--i.e., be cheaper. Your paragraph that starts, "Even though the payout rate grows with age, you have less time to collect," seems to focus on other advantages of annuitization. I can delay purchasing the annuity (perhaps to age 75 or 80) and finance my spending in the short term by investing a touch more aggressively than the insurance company. Am I missing something or are you focused on factors other than longevity?

    ReplyDelete
    Replies
    1. John, Thank you. Eliminating longevity risk is an important reason to consider a SPIA. This short post is based on someone who has already decided to annuitize.

      For more on my take about the great debate between systematic withdrawals and annuitization, where I cover your point, please see

      http://www.advisorperspectives.com/newsletters12/Your_Clients_Toughest_Retirement_Decision.php

      Delete
  3. If you decide on "later", just be careful about making it too much later. Somewhere in mid to late 80s the insurance companies will no longer sell you an annuity. (One agent I spoke with mentioned lawsuits from heirs, even though in that particular case I was one of the "feared" heirs).

    For the past years interest rates have been declining. My experience has been that the declining interest rates have overwhelmed the payout rate increases due to increased age. Buying that annuity in 2008 would have produced more monthly income that buying a larger one today. But how low can rates go? I wonder (and worry)...there doesn't seem to be a zero lower bound, as there is for other markets.

    ReplyDelete
    Replies

    1. Bill, thanks. Are you talking about a SPIA or a different kind of annuity? After one's mid-70s, the payout rates grow sufficiently that it will be quite difficult to beat that with an investment portfolio. So indeed, one does not need to wait too long.

      TIPS yields have no lower bound. Treasury bond yields cannot fall below zero (or, they can ever so slightly if companies get some convenience from holding them instead of cash). The best predictor of future yields is today's yield, so I don't know if they will continue going down or not.

      Delete
    2. SPIA (with an inflation adjustment rider), and Mom was 86 at the time. No agent would make the sale.

      Yield on treasuries has fallen below zero on the secondary market, and I've heard rumblings about negative auction rates. This is for bills and notes, not just TIPS. Need them for collateral; cash is not acceptable.

      As for annuities, the insurance companies can easily quote a negative yield. For a fixed period annuity (say 20 years) it would be obvious when the monthly payout is less than 1/240 of the premium. For normal SPIAs, it would be less obvious.

      Delete
    3. Thank you for the input. I agree.

      Wade

      Delete
  4. Wade--I'd love to see you go further into Anonymous's comment about laddering or averaging. It would seem that in laddering/averaging, you're minimizing the risks of trying to market time while reducing the imputed mortality period each subsequent year.

    ReplyDelete
    Replies
    1. Jason,

      Thanks. It's a good idea. I will try to cover more at a later time about three strategies of this nature:

      -laddering annuity purchases

      -buying a deferred income annuity (a.k.a. longevity insurance)

      -the Russell Investments approach of delaying annuitization as long as possible but always being ready to annuitize if the portfolio drops too much

      Delete
  5. Thank you for this topic! I have been trying to decide when to start my pension - which was converted to a cash balance plan years ago, which I understand will work like a SPIA, so it is also subject to interest rate risk / changes. My wife started her pension last year and our plan was to start mine in Fall 2013 or 2014, hoping interest rates might rise [now less likely, perhaps].

    Our retirement plan is to ladder or stagger our different income sources and thus take retirement funding in stages [my wife has a life expectancy +10 years - at least - more than mine], taking our pensions first, applying later on for Social Security, and leaving our supplemental retirement accounts for still later [perhaps converting some to Roth].

    I am also very interested in deferred income annuities (a.k.a. longevity insurance), so I will look forward to that sub-topic!

    Best wishes for a Happy and Healthy and Prosperous New Year!

    ReplyDelete
    Replies
    1. Thanks Jim,

      It looks like you are doing lots of planning and wish you well!

      Wade

      Delete
  6. Wade,

    In your Feb 12, 2012 article, "Are Annuities OKay when interest rates are low?", you stated, "But buying an annuity now which doesn't begin payments until a later date gives a higher payout than waiting to buy the annuity at that date." That was an important item of information and gave me pause from a SPIA purchase.

    As you relook at deferred annuities, can you please look at deferrals of shorter time periods, such as, 3 years, 5 years, 10 years, etc and just not longevity insurance?

    Many thanks for all your research!

    ReplyDelete
    Replies
    1. Wade,

      Thank you for this thoughtful blog which I think directly answers the e-mail I sent you, and I am sure answers many others' concerns. My understanding is that you can buy now and get a longer series of payments or later and get a higher but shorter series. Apparently there is no benefit to waiting.

      I have done my research at Vanguard through the Huebler Income Solutions platform and discovered something interesting about buying a SPIA. Apparently if you wait to buy six months and one day after your birthday, they treat you as being a full year older and thus getting a higher payout. This is useful if you are on the verge of buying a SPIA now.

      Thank you again.

      Mark Pozner

      Delete
    2. Rich,

      Thanks. I will keep that in mind. It could be a hybrid annuity ladder / longevity insurance.

      Wade

      Delete

    3. Mark,

      Thank you for the email. I apologize for not having responded. It came just before new year when I had the intention of getting my inbox down to zero, but then it kept growing and growing!

      About your point, I still need to analyze this more rigorously, but at a first approximation it does seem that there may not be much benefit from waiting.

      Something else I read recently suggested that mortality rates have been dropping so quickly that annuity companies will have to keep revising payout rates down, and that could counterbalance some of the rate increases associated with one's personal aging.

      Thanks for sharing the interesting point about Income Solutions. I didn't know about that. It could be very beneficial to wait until six months and a day after your birthday to annuitize. I wonder how that works with joint annuities.

      Best wishes, Wade

      Delete
  7. Hi,WADA. Basically am just new for everything I hardly know the things about annuity current rates and all other things so what should I do. My father suggest me very reliable annuity experts so I will also discuss this with them.

    ReplyDelete