Are you getting what you pay for by purchasing an annuity?

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Once upon a time, in the (somewhat mythical) past of traditional defined benefit pensions, your employer protected you from the risk of surviving retirement, by acting, more or less, like an insurance company paying an annuity. With this advantage receding into the past, many experts were hoping that Americans with 401 (k) plans would use annuities on their own, to give themselves the same kind of protection, and, indeed, the SECURE Act of 2019. made it easier for these plans to offer their members a choice of annuity, and, in a survey, 73% of these participants said they “would consider” an annuity upon retirement.

At the same time, however, Americans are wary of annuities – in part because traditional deferred annuities had high fees and expenses and only made sense in an era before IRAs and 401 (k), when ‘they were attractive only because of the limited tax benefits. retirement savings options. But that’s not the only reason – annuities, quite frankly, aren’t cheap.

How to quantify the value of an annuity? On the one hand, it is subjective and personal: do you consider yourself to be in good health, or does your family history and your medication list indicate that you will be among those who will die prematurely among buyers? longer-term pensions? at? Do you want to be sure that you can maintain your standard of living throughout your retirement, or do you think you won’t really care somehow if you have to cut back on spending once you’re in? among the “old-old”?

But measuring the value of rents, in general, tells us whether consumers are getting a fair price for their purchases, and here, a recent working document by two economists, James Poterba and Adam Solomon, “Discount Rates, Mortality Projections, and Money Value Calculations for Individual Annuities in the United States, ”Gives an overview.

Here’s some good news: Using the costs of actual annuities available for consumers to buy in June 2020, and comparing them to bond rates that were similar to investment portfolios held by these insurance companies, the authors calculated “Money value ratios” which show that, for annuities purchased immediately upon retirement, the annuity value ranged from 92% to 94% (give or take, depending on the type) of its cost. This means that the value of insurance protection is relatively modest at 6-8% of the total investment.

But there is a catch, or rather two of them.

First, the authors calculate their ratios based on a standard mortality table for annuity buyers – which makes sense if the goal is to judge the “fairness” of an annuity for retirees by. good health most likely to buy one. But that doesn’t tell us whether an annuity is a smart buy for someone who considers themselves to be in poorer health or with a more uneven family health history, and people in those categories would benefit significantly from an analysis that works for them. is intended, which realistically assesses whether annuities are the right choice and whether their prediction of their life expectancy is likely to be right or wrong.

Second, the calculation of the 92% to 94% monetary value is based on the typical investment portfolio of insurance companies, approximated by the yields of BBB rated bonds. This measures whether the annuity is “fair” or not, in that “moral” sense of whether the perception that the company is “cheating” on customers is real (it is not).

But these interest rates are very low. The authors, in addition to their “value for money” calculations, come back to the implicit discount rate from the annuity costs themselves. For 65-year-old men, this interest rate is 2.16%; for women aged 65, 2.18%.

Now imagine comparing this annuity to an alternative plan of investing your money in the stock market, earning a 7% annual return, and believing that you can predict your date of death (or don’t really care if you fail or if you end up with some money left over for the heirs). The cost of the protection offered by the annuity, the guarantee that you will never run out of money, and that you will not suffer a stock market crash, is indeed very expensive – when you compare apples to oranges like this, l money is worth it. The ratio is, according to my very rough estimates, more like 60%, which means that approximately 40% of your money is spent to buy the “insurance protection” of the annuity.

And, again, it’s not because insurance companies are cheating on anyone; this is only because of the wide spread between corporate bond rates and expected returns when investing in the stock market – a gap that was particularly large in the summer of 2020 when this study was carried out, but which remains almost as wide now. As it is, Moody’s Baa rate are of the order of 3%; in the 2000s, they were around 6% and in the 1990s, from 7 to 9%. While this drop in bond rates is good news for U.S. buyers, as it goes hand in hand with mortgage ratesmakes it much more difficult for retirees to manage their finances in a way that protects them from the risks they face in retirement.

Perhaps interest rates in general, and bond rates in particular, will rise as we move away from our current economic challenges, but there is no certainty, and as long as this gap between bond rates and Expected stock returns will remain so important, retirees will have a hard time finding any sort of safe investment that makes sense to them. Which means that what appears to be of great benefit to Americans looking to borrow money – for mortgages, auto loans, credit cards – may pit the elderly against the young in a generational contest. U.S. against them “.

As always, you are welcome to comment at JaneTheActuary.com!

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