Monday, March 9, 2020

What is the Cost of Real Dollar Lifetime Retirement Income?

Based on financial economics principles, we recommend making assumptions about the future in our Actuarial Budget Calculator (ABC) workbooks that are approximately consistent with those used to price inflation-adjusted annuities.  In part, we recommend these assumptions (rather than more optimistic assumptions based on expected earnings) be used to determine the “market value” of one’s spending liabilities because, in theory, one could settle (or defease) some or all of their lifetime spending liabilities by going out and actually purchasing such an annuity.

Unfortunately, last year the Principal Life Insurance Company (Principal) announced that it would no longer sell single premium immediate inflation (CPI)-adjusted life annuities.   As a result, there are no longer any life insurance companies in the U.S. that offer these annuities commercially.   Several of our readers have asked us how this action will affect our recommended “market value” assumptions for investment return, inflation and lifetime planning periods going forward.  Our short answer is probably not very much.

This post presents background and our rationale for not changing our current recommended assumptions in response to Principal’s action.  The discussion that follows is somewhat actuarial in nature and may not be of interest to all of our readers.  However, it may be informative for those readers who, for whatever reason, believe they should override our default (recommended) assumptions.  


From inception of this blog, we have advocated using investment return assumptions “baked into” current annuity purchase rates rather than estimates of expected returns on more risky investments to calculate present values and to develop personal spending budgets.   Since 2016, when the actuarial profession released the Actuaries Longevity Illustrator (ALI), we have recommended using a combination of three assumptions that we believed fairly closely approximated the cost of purchasing a cpi-adjusted life annuity that may be used to settle spending liabilities.  These three assumptions are:
  • Investment Return: Approximate rate of return consistent with pricing of current nominal (fixed dollar) annuities
  • Lifetime Planning Period: Approximate lifetime planning period from the ALI for 25% probability of survival for a non-smoking male or female (as appropriate) in excellent health
  • Inflation: Assumed investment return minus 2%
We want to acknowledge that we do not know the actual assumptions Principal actuaries used to price either their fixed dollar (nominal) or inflation-adjusted annuity products.   Assumptions used by insurance company actuaries to price their products are generally not shared with the public.   Basic actuarial principles, however, tell us that fixed dollar annuities are generally priced by making assumptions about future investment return(s), future life expectancies (approximately 50% probability of survival) and, of course, certain levels of insurance company expenses and desired profitability.  Thus, if we are reasonably confident about the mortality assumed to price a fixed dollar annuity, we can solve for approximately the investment return assumption, net of expenses and assumed profits.

Solving for the three assumptions used to price an inflation-adjusted annuity is a more complicated process, as there are (at least) three assumptions at play.  But fortunately, we believe it is more important to use a combination of assumptions that produces a reasonable overall cost result than it is to match each assumption actually used.  While we did not perform extensive testing of the combination of three assumptions we have recommended over the past four years, we were able to periodically verify that the combination of these three assumptions produced about the same level of cost as actually quoted by Principal and were reasonably consistent assumptions used to price fixed life annuities.

Note that instead of assuming approximately a 50% probability of survival that is close to what might be used to price either a fixed dollar life annuity or an inflation indexed life annuity, we recommend using the 25% probability of survival.  This adds approximately six years to the lifetime planning periods used by default in our ABC workbooks.  For example, the life expectancy (50% probability of survival) for a 65-year old non-smoking male in excellent health is 23 years and the 25% probability of survival (our recommended or default assumption) is 29 years.  The reason we recommend the latter more conservative assumption is that while an insurance company can make profits selling you an annuity that assumes purchasers live their life expectancy on average, as an individual you must generally plan to live longer than your life expectancy.  As a result of recommending this more conservative 25% probability of survival assumption, we are undoubtedly somewhat more aggressive (optimistic) with respect to our recommended inflation assumption than were Principal actuaries. 

Current annuity rates

On March 9, 2020, the website quoted an average payment of $500 per month for a fixed life only annuity (and $502 per month for a life and 10-year certain annuity) for a 65-year old male residing in Arizona willing to spend $100,000.  Given a 23-year life expectancy (276 months), this works out to about a 3% per annum rate of investment return. 

The table below shows the cost of $1 of annual lifetime income (payable as of the beginning of each year) increasing with assumed inflation based on different assumptions for investment return, inflation and lifetime planning periods shown in the second column.  The fourth column shows initial monthly benefits payable under the assumptions shown in the first column.  The first row (scenario #1) is consistent with the fixed dollar immediate annuity quote of $502 per month discussed above, and differs slightly because of timing differences in assumed payment (the ABC and the chart below assume beginning of year payments, not monthly). 

Assumption scenarios #2 -#5 show similar results for indexed life annuities and various assumed fixed rates of future increases.  Assumption scenario #4 is our current assumption set recommendation.  Note that these costs were developed from our present value calculator and are not quotes from insurance companies.  For purposes of comparison, you should note that the cost produced by our recommended assumptions in scenario #4 are not all that different from the cost produced by the assumptions in scenario #3 (3% investment return, 2.5% inflation and life expectancy of 23 years).  Thus, it could be argued that actual pricing of inflation adjusted annuities assumed something closer to a 0.5% real rate of return.

For comparison purposes, assumption scenario #6 shows results from the March 9, 2020 Cost of Retirement Index (CORI) prepared by BlackRock.  BlackRock uses a proprietary process to develop CORI and does not disclose assumptions.  As you can see from the chart, the cost developed by BlackRock is much higher today than our recommendation.  This was not the case one year ago and implies a significant narrowing of their expected real rates of future investment return.

Why no change at this time

We are not inclined to change our recommended assumptions at this time in response to Principal’s decision to exit the inflation-adjusted life annuity market.  We believe our recommended assumptions produce results that are reasonably close to the cost of providing real-dollar lifetime income at low risk (and more aggressive return assumptions based on expected returns on more risky assets have probably not been properly risk-adjusted).  Further, if the recommended assumptions turn out to be somewhat optimistic or pessimistic estimates of the future, the actuarial process we recommend will automatically adjust for actual experience over time.  


We continue to believe that the cost of providing lifetime real dollar retirement income provides a good low-risk benchmark for valuing lifetime spending liabilities for the purpose of developing an annual spending budget.    Instead of being able to access that cost directly in the commercial insurance markets, we and others will need to estimate that cost through fixed life annuity pricing, pricing of Treasury Inflation Protected Securities (TIPs) and other sources.   In our opinion, however, it is not critical to the budget setting process that the cost and assumptions be 100% accurate.  If you believe that our recommended assumptions significantly understate the cost of retirement, you should feel free to use more conservative assumptions by using the override feature of our workbooks.