Most retirees are in the de-cumulation phase of their life cycle. From their wealth portfolio (balance sheet), they might have a difficult time determining a risk-free monthly income stream for the remainder of their lifetime. This is not surprising, as lifetimes are uncertain, and retirees are correctly worried about outliving their wealth portfolio. Whenever there is a risk that a person wants to eliminate, there is usually an insurance contract they can purchase. But at what price? Or when is the cost of insurance high enough that it is preferable to self-insure. That is, insure with the purchase of an annuity or self-insure by building a do-it-yourself (DIY) annuity.
The decision should include an analysis of the three components of one’s remaining lifetime probability distribution. First is to evaluate the risk-neutral value of the insurance contract from the perspective of the purchaser to compare with the insurance company offer price. An insurance company will take the upfront price you pay for an annuity and invest it to meet your promised monthly income stream. Their profit includes the difference in what their investment portfolio earns and the payout to you plus the guarantee fees of .95% to 1.75% per year, sales commissions, and surrender charges you pay. Second is the value of insurance for outliving your actuarial expected life and the third is dying before you reach your actuarial expected life.
It is important to realize that at any point in time, an annuity salesperson can’t offer you more than is available from their investments in the current bond market, but they can charge you a lot for packaging a lifetime annuity. All of this is buried in the quoted price of the contract. It is useful to know the annuity purchaser’s expected internal rate of return to compare with current bond market rates.
In my book, Do-It-Yourself Wealth Management, I use the example of a 65-year-old male interested in purchasing a lifetime annuity. Online quotes all exceeded $500,000 for receiving $2,500 per month for his remaining life. Calculating the expected internal rate of return on the annuity purchase requires an expected maturity. From an actuarial life table, a 65-year-old male is expected to live another 17.84 years. For the $512,287 quote I received, I solved for its 0.61% expected internal rate of return. At that time (October 17, 2019), a Treasury bond with a duration of 18 years had a 2% yield. The present value of $2,500 per month with a 2% discount rate for 18 years is $453,172. In other words, we can create an 18-year $2,500 per month annuity for $453,172 and save $59,115. In my book, the implementation of this DIY annuity is illustrated with three Treasury funds designed to have no default risk and be immunized from interest rate risk.
Paying $59,115 now for insurance against living longer than an 18-year expected remaining life to receive $2,500 per month seems expensive. The $59,115 savings is nearly 2 years of monthly payments past the 18 years plus income on it in the meantime will get closer to 3 years of additional payments. The most obvious reason for the annuity being expensive is the current low interest rate environment relative to all the fees imbedded in the contract. Annuity contracts were a hot commodity in the 1980s when Treasury rates were above 10%, Then the drag on investment performance from the fee structure was less noticeable. You might think that the industry should be reducing fees to accommodate the lower interest rate environment and sell more contracts. Instead, they may be better off profiting more from those consumers that are not knowledgeable enough to distinguish between the elements of the contract.
Maybe you are thinking I am not giving enough value to the downside risk of living longer than expected in a lifetime annuity? When it comes to risk management, I will always advocate for eliminating uncompensated risk. However, personal attributes, investment objectives and risk tolerance must be incorporated into decision-making when there is a tradeoff between risk and expected return.
For example, if you expect to live longer than the average of your cohort, that increases your view of the expected internal rate of return and expected insurance contract value. For an extreme example, if you are certain (100% probability) to live 20 years past your forecasted life (103 versus 83), then the present value of $2,500 per month for 18 years + 20 years = 38 years is $798,056. That would make the insurance piece cheap from your perspective. That is, more valuable to you than what the insurance company is charging. Although this is an extreme example of living 38 more years for certain, it makes the point that your personal attribute of health assessment relative to your cohort and your degree of risk-aversion will affect your subjective valuation of the lifetime guarantee being offered.
The other part of the risk-expected return spectrum that I believe does not get enough attention in annuity valuation is the risk of death prior to one’s expected lifetime. A death 2 months after paying $512,287 for a $2,500 per month lifetime annuity is a substantial downside risk for a spouse and other potential beneficiaries. The value and securities contained within a DIY annuity, however, does not disappear if you die before it matures. Instead, it remains intact and can be exchanged or altered by the beneficiaries.
In summary, the decision of whether to buy an annuity to insure against outliving your investment income or build a DYI annuity as self-insurance depends on an evaluation of the cost structure of the annuity, the risk-neutral valuation of the contract, the component value of insuring against living longer than actuarially predicted, the downside risk of death earlier than predicted and subjective personal attributes including health outlook and degree of risk-aversion.
The build decision is clearly superior for the risk-neutral valuation and the downside risk of death before expected part of the remaining lifetime distribution. While personal attributes will determine the decision for living longer than expected part of the remaining lifetime distribution, there is a strong case for the build decision here as well. You can structure a DIY annuity for any expected lifetime to hedge against living longer without paying all the embedded insurance costs. The savings from not buying the insurance contract can be used to extend the DIY annuity several years. It is also reasonable for a long-term DIY annuity to use investment grade corporate and mortgage-backed securities with its higher expected yield at very low incremental risk to extend your annuity. Essentially, set a personal comfort level (e.g., 5, 10, or 20 years) more than your actuarial expected life to hedge against living too long in your building of a DIY annuity.
BTW, Ripsaw® Wealth Tools considers annuity, pension and social security contracts as part of your bond portfolio for wealth management. It also provides calculations of risk-neutral market values and risk dimensions.
Stanley J. Kon is Chairman of Ripsaw LLC where he oversees research, education, and product development. He also is the editor of the Journal of Fixed Income. Dr. Kon has written extensively in the areas of investment management, performance measurement, asset pricing, statistical models of stock returns and mortgage-backed securities. He has published articles in the Journal of Financial Economics, Journal of Finance, Journal of Business, Journal of Empirical Finance, Journal of Fixed Income and Financial Analysts Journal. He served as the J. B. Fuqua Visiting Professor of Finance at Duke University’s Fuqua School of Business where he taught courses in fixed income securities and risk management. He was also a Visiting Professor at New York University’s Stern School of Business where he received the Executive MBA outstanding teacher award. Prior to that, Stanley was a principal, executive vice-president, director of research and co-director of the investment management group at Smith Breeden Associates, Inc., an institutional investment management company. Prior to that, he was a Professor of Finance at the University of Michigan from 1982-1997. Prior to 1982, Professor Kon served on the faculties of New York University, the University of Chicago and the University of Wisconsin at Madison. Dr. Kon has also served on several bank and holding company boards and as a consultant to government, business and financial institutions. Dr. Kon received his BS in Chemical Engineering from the Lowell Technological Institute, his MBA in Finance and Economics from St. John’s University and his PhD in Finance from the State University of New York at Buffalo.