The last update to the Retire Early Home Page in September reviewed the fixed income options for a retirement portfolio. Among the options considered, it was noted that single premium immediate annuities (SPIA) carry very high costs, and as such, are a good deal for almost no one.
Shortly after Retire Early's fixed income article was published, PBS Newshour business reporter Paul Solman interviewed author Dr. Lew Mandel on his new book What To Do When I Get Stupid: A Radically Safe Approach to a Difficult Financial Era. They discussed Single Premium Immediate Annuities (SPIA) under the provocative headline below. (Click on the headline to read the article.)
In the interview, Dr. Mandel made a couple of rather extravagant claims for SPIA's. You'd probably need to be over 70 years of age to find an annuity with an annual benefit of 8.3% of the premium paid. And you wouldn't realize an 8.3% return on your money even if you lived to be 150 because, unlike a bond, your principal is never returned to you with a SPIA. Mandel also downplayed the hidden costs of SPIAs saying "Profits are generally low, with total markups (according to my calculated estimates) of no more than about 1 percent." Profits may be low, but all the other hidden costs can consume 20% to 30% of the purchase price for a person of average mortality.
What's the investment return on a Single Premium Immediate Annuity?
It depends on when you die. The table below shows the investment return for a 70-year-old male purchasing a nominal annuity (i.e., not inflation-adjusted) with an annual benefit of 8% of the premium paid. The Mortality Percentiles are from the 2009 Social Security Mortality Table and reflect the population at large. Half of the 70-year-old male cohort are expected to die by age 84. One in ten should reach age 94, and 1 out of 100 would be expected to top 100 years of age. On the downside, a full quarter of our group of 70-year-olds are estimated to die by age 78, making an annuity a terrible "investment" for them.
What are the hidden fees, expenses, and costs of a Single Premium Immediate Annuity?
You can estimate the costs embedded in a single premium immediate annuity by comparing the premium quote you get from the insurance agent to the expected present discounted value (EPDV) of an immediate life annuity. The EPDV is sometimes called an "actuarially-fair annuity" or "money's worth annuity". Economists define the ratio between the EPDV and the premium quote as the Money's Worth Ratio (MWR).(Note 1.)
For individuals of average mortality, Money's Worth Ratios as low as 0.70 are not uncommon, depending on the annuitant's age and current interest rates. That would indicate that 30% of the purchase price of the SPIA is siphoned off in the insurer's various costs and expenses. For retirees who are aquainted with low-cost index funds where one can assemble a diversified portfolio of stocks and fixed income securities for an annual cost of less than 15 basis points (0.15%) in fees, the embedded costs of an SPIA seem large enough to choke a crocodile. Even if you applied a 15 basis point annual fee over the entire 50 to 60-year life of the annuity pool, it would still amount to less than 2% of the purchase price of an SPIA.
How do you calculate the Expected Present Discounted Value (EPDV) of an immediate life annuity?
To calculate the expected present discounted value, you'll need an appropriate mortality table and discount rate. There is tremendous adverse selection in the individual annuity market, so it's best to make the calculation two ways; 1) the value of the annuity for the average person and, 2) the value of the annuity for the much healthier segment of the population that actually buys annuities. If you're not blessed with the good health and long-lived genes of the typical annuity purchaser, you'll end up overpaying for the product relative to its value.
The Social Security Administration publishes a Mortality Table that describes the life expectancy for the population has a whole (i.e., the average person.) While every insurance company developes their own proprietary mortality table based on the specific markets they target, this information is not in the public domain. Mitchell, Poterba, et al (Note 2) have done work on estimating the affect of adverse selection in the individual annuity market. The information from Table 2 in Mitchell's article on the relative mortality between the general population and annuitants was used to adjust the 2009 Social Security mortality table for adverse selection. The adjustment places the median annuitant in the 66th percentile of the mortality distribution for the general population as described by the 2009 Social Security table. This translates to a 4.5-year spread for adverse selection for a 55-year-old male and bit over 3 years for a 70-year-old male. The adverse selection figures for women cluster in a tighter range.
The "risk-free" rate for US Treasuries is the most conservative choice for a discount rate. For nominal annuities, the yield on 30-Year US Treasuries is a reasonable choice. For inflation-adjusted annuities, the current real yield on the 30-Year Treasury Inflation-Protected Security (TIPS) is an appropriate benchmark. The table below compares the expected present discounted value (EPDV) with annuity premium quotes from the Principal Life Insurance Company. If you want to do your own expected present discounted value (EPDV) calculation, you can download a copy of the Retire Early spreadsheet, click here.
Why are immediate life annuity costs so high?
There are several identifiable costs that could explain the wide gap between the insurer's premium quote and the low Money's Worth Ratios (MWR) observed here:
Interest Rate and Reinvestment Risk. To the extent that the longevity of people in the annuity pool exceed the maturity of readily available fixed income securities, insurers bear some risk that they won't be able to reinvest the proceeds on maturity at an equal or higher interest rate for the portion of the annuity pool that remains. However, life insurers typically invest in instruments with higher yields than the US Treasury TIPS and AA-rated corporate bonds we've assumed here. James and Song (2001) (Note 3) found that the yield on insurance company portfolios exceeded the risk-free rate by 1.3% or more per year. Some, most, or all of the interest rate and reinvestment risk may well be covered by that spread.
Administrative Overhead and Profit. Insurance companies typically occupy high-rent, luxury office towers, maintain fleets of well-upholstered private jets for the highest echelon of management, and sometimes even pay multi-million dollar compensation packages to failed executives. For example, angry shareholders of The Hartford (NYSE: HIG) recently forced the retirement of long-time CEO Ramani Ayer who worked his management magic to deliver a more than 50% decline in HIG's stock value over his 12-year reign. Absent any executive compensation restrictions imposed by the US Government's bailout of The Hartford, Mr. Ayer received over $4 million in compensation for 2008.
Distribution and Marketing Costs. Sales commissions of 3% to 4% of the annuity premium, advertising costs, and incentives like this week-long retreat at the 5-star St. Regis Monarch Beach resort in California (including a $23,000 bill for massage and spa services) apparently add quite a bit to the cost of an immediate annuity. There are no happy endings for retirees underwriting this largess.
Can you provide lifetime income without incurring the high costs of a commercial insurer?The table below illustrates this result for a 62-year-old (born in 1944) who retired in 2006 with the maximum benefit. It's interesting to note that "buying" an annuity from the Social Security Administration costs a 70-year-old female 52% less than purchasing the same benefit from a private insurer (e.g. Principal Life).
If you want to run your own numbers, you can download a copy of the Excel spreadsheet, click here. (file size= 30 KB)
The affect of taking Social Security early, at age 62, or delaying benefits until age 70
The Social Security Administration publishes a handy table that summarizes how your monthly benefit is affected by the age you start collecting benefits. For the retiree born in 1941 in our example, starting Social Security benefits at age 62 results in a monthly benefit that's just 76-2/3% of what he'd receive at his full retirement age of 65 years, 8 months. Delaying benefits until age 70 results in a monthly benefit that is 32-1/2% larger. In other words, delaying benefits from age 62 to age 70 results in a monthly Social Security check that's 132.5/76.67 = 72.4% larger.
What are the risks of waiting?
Political Risk: No one knows what changes Congress and The President might make to Social Security. Despite the considerable financial benefit of waiting, this leads many people to take it early, at age 62, on the theory that any changes will mean they'll get less in the future.
Mortality Risk: The Social Security Administration's own Mortality Table predicts that 14% of 62-year-old men and almost 10% of the women will be dead by age 70. Clearly waiting until age 70 to collect your benefits is the wrong decison for these hapless retirees. Many analysts put the break-even point for delaying Social Security from age 62 to age 70 at somewhere around age 79 (i.e., a retiree waiting until age 70 to start benefits must live to at least age 79 before he collects as much money as a retiree who started at age 62 with a lower benefit.) About 41% of 62-year-old men and 30% of the females won't live that long. If you want to get an estimate of your own life expectancy, the University of Pennsylvania has an easy to use calcuator on their web site. You'll also find links to a number of other longevity calculators in this article.
Calculating the Breakeven Point (Age) for delaying Social Security benefits
The breakeven point (age) depends on the investment returns for the retirement portfolio you will deplete in lieu of taking Social Security at age 62. Two examples are presented below; one for a 2% nominal investment return and the second for a 10% return. Three scenarios are examined 1) Take Social Security at age 62, 2) Wait until age 70 to start Social Security benefits, and 3) Take Social Security at age 62, and then buy a life annuity from a private insurer at age 70 to make up the difference in benefits.
What to conclude from these results?
Because a retiree will only see 8 years of compounded returns from age 62 to age 70, the rate of return doesn't have a big effect on the break-even age. Moving from a 2% nominal investment return to a 10% return only increased the breakeven age two years, from 78 to 80. The worst alternative was taking benefits at age 62 and then buying an annuity from a private insurer at age 70 to make up the difference in the monthly benefit which added another 6 to 8 years to the breakeven age. If there is any chance that you might purchase an annuity to supplement your retirement income, the least expensive way to "buy" that benefit is to delay your Social Security until age 70.
1. The Role of Real Annuities and Indexed Bonds in an Individual Accounts Retirement Program, Jeffrey R. Brown, Olivia S. Mitchell and James M. Poterba, 1998, The Wharton School.
2. New Evidence on the Money's Worth of Individual Annuities, Olivia S. Mitchell, James M. Poterba, Mark J. Warshawsky and Jeffrey R. Brown, December 1999, American Economic Review.
3. Annuities Markets Around the World: Money’s Worth and Risk Intermediation, Estelle James and Xue Song, October 2001, American Economic Association.
Resources for more information
Optimal Annuitization with Stochastic Mortality Probabilities: Working Paper 2013-05 , By Felix Reichling and Kent Smetters
IS ADVERSE SELECTION IN THE ANNUITY MARKET A BIG PROBLEM? , Anthony Webb, 2006, Boston College, Center for Retirement Research
The Annuity Puzzle and Negative Framing by Jeffrey R. Gerlach,Julie Agnew,Lisa R. Anderson and Lisa R. Szykman, 2008, Boston College, Center for Retirement Research
The Principal Financial Group annuity quotes a listing of their current annuity payouts.
Berkshire Hathaway annuity quotes online calculator gives you an immediate quote.
Forbes magazine Guaranteeing Lifetime Income.
Assessing Investment and Longevity Risks within Immediate Annuities, Daniel Bauer, Frederik Weber, 2007, Munich School of Management.
Immediate Annuity Pricing in the Presence of Unobserved Heterogeneity , Kim G. Balls, 2004, Managing Retirement Assets Symposium - Society of Actuaries
Hewitt Associates - 401(k) index some interesting information on how people allocate their retirement acounts.
Lifetime Financial Advice: Human Capital, Asset Allocation and Insurance, by R.G. Ibbotson, M.A. Milevsky, P. Chen and K.X.Zhu
Social Security Handbook -- information on your Social Security benefits.
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Copyright © 2013 John P. Greaney, All rights reserved.