The Real Value of Annuities for Mass Affluent Retirees
Consider two retirees. Mary has a pension and Social Security that provide a combined $60,000 of annual income. John only has $25,000 in Social Security. Are the consequences of running out of savings the same for Mary and John? Is John worse off if he buys an annuity that increases his lifetime income to $60,000 but increases the probability of running out of savings?
Probability of success can be misleading and provides guidance that is clearly suboptimal when making decisions around guaranteed income.
If we use the probability of success to determine the optimal initial withdrawal rate from a portfolio, the recommended spending level would be the same whether the retiree is already receiving $10,000 or $100,000 in guaranteed income. By definition, the withdrawal rate should be greater if the existing level of guaranteed income is higher because the overall magnitude of “failure” is lower.
In other words, retirees with a greater base of guaranteed income or a lifetime withdrawal benefit from a portfolio will optimally spend more each year than a retiree who faces the risk of a sharply lower lifestyle if markets fall.
Perhaps the greatest value of partial annuitization is simply the ability to optimally spend more each year from savings free of the worry that poor market returns or a long lifespan will jeopardize a retiree’s lifestyle.
Retirees gain no benefit in expected lifestyle by bearing the idiosyncratic risk of spending with an unknown lifespan. Annuities improve efficiency by allowing these retirees to transfer this risk to an institution, and by transferring this risk they can achieve a more secure retirement. Our concern with these analyses is that retirees won’t live as well as they could in the absence of income guarantees.
It’s exciting to finally see the growing interest in annuities today among both DC plan sponsors and financial advisors. The attention toward the merits of annuities and how they can play an important role in allowing retirees to spend more with less risk by protecting against the idiosyncratic risk of unknown longevity is long overdue.
Jason Fichtner is chief economist at the Bipartisan Policy Center; Michael Finke is a professor and Frank M. Engle Chair of Economic Security at The American College of Financial Services. Both are research fellows with the Alliance for Lifetime Income’s Retirement Income Institute.
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