Nested Interest

Annuities have been on the receiving end of harsh criticism for as long as I can recall.  Typically, critics point to high fees and high commissions (although no-load annuities can easily be tracked down using a search engine); more legitimately, critics point to overly complex features that are confusing to consumers and difficult to evaluate.  Not surprisingly, some financial advisors have suggested that investors may be better off “building their own annuities” in lieu of purchasing one from an insurance company as a way to cut costs.  To many, this is enticing – being able to create a secure income stream for retirement while maintaining full control of your assets sounds like a no-brainer.

However, after comparing these alternative strategies to annuities, and understanding the economics that make annuity programs tick, it will become evident that any attempt to “self-annuitize” is an exercise in futility.

Focus on Immediate Annuities

First, let me be clear that my comments strictly pertain to immediate annuities – the ones that pay its annuitants a lifetime income benefit, and that do not provide a cash value to its owner.

How Income Annuities Work

Most people think that an annuity arrangement works by making a payment to an insurance company, and the insurance company, in turn, paying the annuitant a monthly or annual income payment for the rest of his or her life.  On the surface, this is correct, but there is much more going on behind the scenes than most people realize.

You see, annuities are an insurance product, and like other insurance product they involving the pooling of with others that are participating in the insurance program.  In the case of annuities, the risk is living well beyond your life expectancy.  No one dies exactly on their life expectancy – roughly ½ of us will not reach their life expectancy, and another ½ will live beyond their life expectancy.  If we knew exactly how long we were going to live, retirement income planning would not be as complicated as it is!

To illustrate how annuities pool risk, let’s look at a simple example.  Suppose:

• there are 10 retirees that each have $100,000 and want as much retirement income as they can get, without having any risk of outliving their money.
• each person knows that 1 person will die each year over the next 10 years, but no one knows who will die when.
• money earns zero interest

What is the best way to design an income benefit structure – one that creates the most income to each person with the least amount of risk?  Let’s explore a few options:

Option #1:  “Self Annuitization” to Life Expectancy

Under this approach, we note that each person’s life expectancy is approximately 5 years, so they would spend $100,000/5 = $20,000 per year:

Result:  4 of the 10 will leave an unspent amount of their savings to their heirs; 5 of the 10 will run out of money and outlive their assets.  One will be “lucky” and die on his life expectancy.  This solution therefore “fails” our quality standard because it exposes some to the risk of outliving their assets.

Option #2:  “Self Annuitization” to 10 years

Under this approach, each person spends $100,000/10 = $10,000 per year, a much lower amount than under Option #1:

Result:  All of the 10 will never run out of money, so we meet our quality standard.  However, each person will have to spend a considerably smaller amount, and 9 will leave an amount of unspent savings to their heirs.

As you can see, neither of these “Self Annuitized” solutions is perfect.  Is there a better way?

Option #3: The Annuity Solution

Under this approach, the 10 individuals pool their savings and calculate an annual amount of income that each person can withdraw such that the balance is exactly zero when the last survivor takes out the final payment.  No one is allowed to take money out of this saving expect to get their promised income benefit.  How much annual income can this arrangement generate to each person?

The total amount of savings is 10 x $100,000 = $1,000,000.  In the first year, there will be a total of 10 payments (one to each person).  In the second year, there will be a total of 9 payments (after one person dies in year one).  In the third year, there will be 8 payments.  This continues until year 10 when the last payment is made to the final survivor.

We can therefore calculate the annual income that can be paid to each person by dividing the initial savings ($1,000,000) by the total number of payments that will be made over the 10 year period, as follows:

$1,000,000 / (10+9+8+7+6+5+4+3+2+1) = $1,000,000 / 55 = $18,181.18

 

 

 

 

 

 

 

 

So, by pooling their money each person was able to increase their income substantially more than Option #2, and without having the risk associated with Option #1.  Pretty cool!

Final Observations

They key to the “magic” of annuities lies within the pooling of risk that such programs offer.  By agreeing to pool their money, the savings left from those dying before their life expectancy is used to cover the shortfall that occurs from those that live beyond their life expectancy.  This can be seen by looking at the difference between the initial savings that each individual contributed to the pool and the total amount of withdrawals that they each made:

 

 

 

 

 

 

 

 

As this chart shows, some individuals ended up taking out less than the amount they withdrew while others ended up taking out much more, but the sum total of all of these differences is exactly zero – actuarial perfection!

In short, if there is no pooling of savings you cannot replicate the economics of an annuity.  Any attempt to do so will either produce a much lower level of income, or expose you to a greater risk of outliving your assets.