Who Benefits Most From Annuity Purchases?

The authors’ approach to addressing this question is to embed annuity purchases and claiming decisions in a full life cycle model, which starts at age 25 and runs to age 100. As the authors explain, the model seeks to analyze optimal saving and investing across bonds and risky stocks with respect to individuals’ choices about consumption and their withdrawal patterns for assets inside and outside the DC plan.

“Our model also includes heterogeneity in lifetime earnings, assets and mortality across education groups, and importantly, we incorporate important institutional aspects including the progressive and complex U.S. income tax code and Social Security benefits formula,” the authors say.

The authors take further pains to investigate optimal annuitization ratios for both fixed as well as variable annuities and alternative deferral ages. Additionally, they seek to “realistically calibrate” their model’s parameters, using a matching procedure to select preference parameters so that the model results match the empirically observable assets invested by U.S. workers in tax-qualified defined contribution retirement plans as closely as possible.

Finally, they use the model to analyze the demand for, and welfare consequences of, four alternative approaches. Specifically, they examine the results of claiming Social Security at age 66 versus 67 (without access to deferred income annuities) and of claiming Social Security at age 66 with access to fixed or variable DIAs.

Drawing Conclusions, and What it Means for Advisors

According to the authors, the results of this intricate analysis show that using retirement account assets to purchase at least some fixed deferred income annuities benefits all demographic groups examined. They further find that allowing payout annuities to have a small exposure to equity can additionally enhance welfare.

Nevertheless, for the least educated, delaying claiming Social Security benefits is preferred, according to the authors. There are a variety of reasons for this, including the fact that the least educated tend to be the lowest earners, and thus optimized Social Security claiming decisions will simply have a greater impact on their overall lifetime wealth. Another consideration is the relative simplicity of delayed Social Security claiming in comparison to other strategies that involve carefully timed taxable distributions and annuity purchases.

“Lower educated retirees … fare much better if they delay claiming and use retirement assets to bridge their consumption needs, versus buying DIAs,” the authors suggest. “This is because the least educated have a higher Social Security replacement rate and a higher mortality risk, whereas the better educated receive relatively lower Social Security benefits and can anticipate longer lifetimes.”

According to the report authors, the welfare gains available from optimized utilization of annuities and careful Social Security claiming typically range between $25,000 and $50,000.

One important caveat in the report is that current regulatory policy stipulates that variable annuities are disallowed as qualified longevity annuity contracts within U.S. retirement plans. The authors suggest that this policy may warrant reconsideration, as their results show well-designed and affordably priced variable deferred income annuities in retirement plan portfolios can markedly enhance retiree financial well-being.

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