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.