At How Much You Can Afford to Spend, we encourage retirees (and retired couples) to adopt a Liability Driven Investment (LDI) strategy and consider building a Floor Portfolio of low-risk assets to fund their essential expenses. Low-risk assets include lifetime income sources like Social Security, pensions and life annuities as well as other investments like cash and individual bonds. In our post of February 2, 2021, we discussed how relatively easy it is to build your own Floor Portfolio.
For many reasons, many retirees don’t relish the idea of buying life annuities from insurance companies. Some of these reasons include:
- Annuities seem to be very expensive.
- Annuities are less flexible than other types of investments
- Annuities don’t appear to be consistent with goals of leaving money to heirs,
- Individuals don’t like losing control over a large chunk of their hard-earned savings,
- Individuals believe they can achieve higher returns by managing their own assets,
- Individuals already have sufficient Social Security benefits or pensions,
- Individuals don’t understand annuities, and
- Individuals fear dying before receiving a reasonable return on their investment
We aren’t life annuity salespeople, and we aren’t going to push you to purchase a life annuity if you don’t want one. We are, however, going to point out in this post that for the purpose of building a Floor Portfolio, annuities (and other lifetime income sources) can be relatively efficient when compared with some other types of low-risk investments like bonds. And, they can actually be worth more in your Floor Portfolio than what you pay for them.
Planning for a Longer Life
One of the basic principles of prudent retirement planning is to plan to live longer than you expect. In our post of September 5, 2020, we referred to a Morningstar Research report authored by David Blanchett that recommended that individuals (or their financial advisors) develop retirement plans by assuming lifetime planning periods in excess of life expectancy. In his report, Dr. Blanchett said:
“Through simulations it is determined that adding five years to the life expectancy estimate for a single household, and eight years to the longest life expectancy of either member of a joint household (or to each member if separate end ages are used for spouses), at the assumed retirement age, is a reasonable approach to approximating the retirement period…”
As noted in that September 5 post, the five-year and eight-year additional years noted by Dr. Blanchett are approximately the differences in years between the 50% probabilities (life expectancy) and the 25% probabilities of survival from the Actuaries Longevity Illustrator (ALI) that we recommend for the default assumptions in our Actuarial Budget Calculators (ABCs).
While assuming longer-than-life-expectancy periods of retirement will increase the number of years of expected expenses in retirement (i.e., your spending liabilities), it will also increase the number of years that your lifetime streams of payments like Social Security, pensions and life annuities (assets) may be expected to be paid. Therefore, this longer-than-life-expectancy strategy favors lifetime payment types of assets over non-lifetime payment types assets like bonds when it comes to building your Floor Portfolio.
The effect of the longer-than-life-expectancy strategy on the value of lifetime forms of payment like annuities (which we will illustrate in the next section) is similar in concept to comparing the “insurance value” vs. the “expected value” of such payment forms as discussed in the recent Center for Retirement Research at Boston College brief entitled, “What is the Value of Annuities?”
Value of Annuities Available Today
To demonstrate the value of annuities under the longer-than-life expectancy strategy discussed above, we went to ImmediateAnnuities.com and obtained monthly payment quotes for immediate and deferred single life annuities that may be purchased (for an annuitant residing in Arizona) with a $100,000 single payment premium for males and females of various ages as of March 10, 2021. Using our ABCs, we then determined the present value of these annuities using a 3% interest rate and our default lifetime planning period based on 25% probability of survival for non-smokers in excellent health. For comparison purposes, we also developed present values using life expectancies (50% probability of survival) from the Actuaries Longevity Illustrator (ALI) (also for non-smokers in excellent health). For those who would like to check our calculations, you will need to use override assumptions for lifetime planning periods and view the present value calculations in the PV Calcs tab. Note that because the ALI produces results to the nearest year, there may be minor discontinuities in the results. The results are shown below separately for males and females.
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Takeaways:
- Monthly immediate annuity quotes for females of a given age are approximately the same as for males two years younger
- Lifetime planning periods (in years) associated with 50% or 25% probabilities of survival for females of a given age are approximately the same as for males two years younger.
- Values of immediate annuities based on 50% or 25% probabilities of survival are approximately the same for males and females of the same age.
- At a 3% discount rate, the present value of immediate annuity payments based on a 50% probability of survival is fairly close to the $100,000 premium cost except at ages over 70.
- Values of immediate annuities based on 25% probabilities of survival exceed the $100,000 premium cost and are approximately 11%-12% higher than premium cost for 60-year-old annuitants, increasing to about 15%-16% higher for 76-year-old annuitants.
- Monthly deferred to age 85 annuity quotes for males are significantly higher for males of a given age than for females of the same age as a result of the longer life expectancies of females (and the fixed age 85 payment starting date).
- At a 3% discount rate, the present value of deferred annuity payments based on a 50% probability of survival is less than the $100,000 premium cost for all ages and significantly less for males than females.
- Values of deferred annuities based on 25% probabilities of survival are much higher than premium cost for both males and females, with values exceeding premium costs by about 46%-51% for the younger annuitants and around 25% for older annuitants.
Conclusion
There is no question that life annuities today are expensive relative to historical costs. And, life annuities may not necessarily be a good investment for individuals who have reasons to believe that their life expectancy may be less than that of non-smokers in excellent health. On the other hand, adding five or eight years to your estimated life expectancy as suggested Dr. Blanchett or using a 25% probability of survival in developing a lifetime planning period may make annuities more attractive vehicles for funding your Floor Portfolio. We are not pushing annuities. This post simply provides some data points for your consideration. In addition to determining the present values of annuities based on a 25% probability of survival, our workbooks can also be used to determine the present values associated with selecting the annuity vs. a lump sum from your pension plan or of deferring your Social Security benefit.
