"Annuity Puzzle" really no puzzle at all.

"Annuity Puzzle" really no puzzle at all.

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This article was first posted July 1, 2020.

I recently came across this article in Forbes where "Professor of Retirement Income" Wade Pfau gives us his thoughts on the "Annuity puzzle" (i.e., the fact that economists and "investment professionals" can't believe that the public doesn't see an advantage in buying a single premium life annuity.)

Professor Pfau writes:

What’s more, real-world annuities will have overhead charges as insurance providers must cover expenses, make a profit, and account for adverse selection and misestimation risks. These costs reduce payout rates and the potential gains from annuitization. Nonetheless, as we have discussed, the fees built into income annuities do not appear as large as may be commonly thought.


That bolded passage above from Professor Pfau is a fairly startling observation.

It's actually quite easy to compare a "no-fee", actuarily-fair life annuity with the price quote you'd get from an insurance company.

The Social Security Administration will allow you to delay the start of your benefits to age 70. The benefits one would collect during that eight year period between the earliest date one can claim at age 62 to the latest date at age 70 reflect the "price" one would pay for the roughly 75% larger benefit at age 70.


Because the early retirement reduction factors (which reduce benefits for claiming early) and DRCs (which increase benefits for claiming later) are roughly actuarially fair, lifetime benefits are about the same for the average beneficiary regardless of claiming age.3 For individuals who retire early, monthly benefits are reduced to take into account the longer period of time they are received. For individuals who retire later, the higher monthly benefit takes into account the shorter period of time they are received.

To illustrate this we take the example of a retiree turning age 70 on Jan 1, 2020 who has 35 years of maximum FICA earnings and would get the maximum Social Security benefit. (See spreadsheet below.) If our retiree took his benefit at 62, he would have received $1,855 month and would have collected a total of about $186,000 in benefits over the next 8 years.

Our retiree would also pay income taxes on the $186,000 and lose the investment return on the $186,000 he would have to spend from his investment accounts. I've used a 25% marginal tax rate and a 2% investment return in the example, but you can enter any numbers you like in the spreadsheet. (Note: You'll need to open a full size spreadsheet by clicking the button on the bottom right hand corner of the embedded spreadsheet to enable the editing function and enter your own numbers.)

To keep it an apples-to-apples comparison, you probably shouldn't use more than the 2% or so you'd get from an FDIC-insured Certificate of Deposit since the idea is that the funds would be available to buy an annuity at age 70. Of course, from Jan 1, 2012 to Jan 1, 2020, the S&P 500 returned 14.4% annualized (dividends reinvested), but you may not want to count on that over the next eight years. The stock market goes down, too. But even if you use that 14.4% annualized return, you'll fall well short of what a commercial insurer would charge for a $1,617/month benefit at age 70 (i.e., $126,000 shortfall for men, $155,000 for women.)

At age 70 our retiree would get a $3,663/month benefit, a $1,617/month increase over the $1,866 he would have collected at age 62.

Next we need to get a price quote on an $1,617/month inflation-adjusted life annuity for a 70-year-old. Very few insurers sell a true inflation-adjusted annuity indexed to the CPI-U like Social security. The best you can do is to get a fixed inflation adjustment of 2% or 3% per year. When you can find an annuity indexed to the CPI-U, it's usually priced at about the cost of a 2.5% fixed inflation adjustment, so we can use that. Fidelity has an online annuity quote estimator you can use for this purpose. Just ratio the 2% inflation adjustment they offer up to 2.5%

You can download a copy of the spreadsheet at this link: SS_2020_06_22-x.xlsx

Why are immediate life annuity costs so high?

There are several identifiable costs that explain the wide gap between the insurer's premium quote and the value of the delayed Social Security benefits plus a reasonable investment return.

    Adverse Selection and Mortality Risk. Between one-third to one-half of an annuity's embedded costs can be attributed to the mortality difference between the general population and much healthier annuitants (i.e., adverse selection.) The Social Security Administration has a risk pool of over 60 million beneficiaries. Even the largest annuity sellers have a small fraction of that. This should be of special concern to annuity purchasers of average life expectancy since it greatly increases the cost of the commercial annuity relative to the value received.

    Interest Rate and Reinvestment Risk. To the extent that the longevity of people in the annuity pool exceed the maturity of readily available fixed income securities, insurers bear some risk that they won't be able to reinvest the proceeds on maturity at an equal or higher interest rate for the portion of the annuity pool that remains. However, life insurers typically invest in instruments with higher yields than the US Treasury TIPS and AA-rated corporate bonds we've assumed here. James and Song (2001) (Note 3) found that the yield on insurance company portfolios exceeded the risk-free rate by 1.3% or more per year. Some, most, or all of the interest rate and reinvestment risk may well be covered by that spread.

    Administrative Overhead and Profit. Insurance companies typically occupy high-rent, luxury office towers, maintain fleets of well-upholstered private jets for the highest echelon of management, and often pay multi-million dollar compensation packages to failed executives just to get rid of them. Meanwhile, the Gov't bureaucrat running the Social Security Administration earns less than $200,000/yr and flies commercial.

    Distribution and Marketing Costs. Sales commissions of 3% to 4% of the annuity premium, advertising costs, and incentives like this week-long retreat at the 5-star St. Regis Monarch Beach resort in California (including a $23,000 bill for massage and spa services) apparently add quite a bit to the cost of an immediate annuity. There are no happy endings for retirees underwriting this largess.

Nothing upsets an annuity salesman or a "risk professional" more than when you point out that delaying Social Security to age 70 allows you to "buy" an inflation-adjusted life annuity at a big discount to what an insurer would charge. For someone collecting the maximum Social Security check, it's about a $202,000 savings for men, $230,000 for women ($300,000 - Men/$345,000 - Women if you include the 50% spousal benefit.) That's real money unless your net worth is well into the "1%". {LOL}

If you believe that you're likely to live beyond the age of 82 or so, it makes financial sense to delay the start of your Social Security benefits to age 70 if you can afford to do so. Delaying Social Security from age 62 to age 70 increases your monthly benefit by about 75%. A larger, inflation-adjusted Social Security benefit allows for smaller retirement portfolio withdrawals. Thus, improving the chance you won't outlive your money if you see the longer lifespan forecast for high income earners.

Resources for additional information.

Social Security Administration website

Fidelity Gauranteed Income Estimator

Which Annuities Offer the Best Inflation Protection?

The Annuity Puzzle: Other Issues Impacting The Annuity Decision

CNBC -- The RMD Retirement Strategy

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