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Carla Fried: Expect to live a while in retirement? Set aside your distaste for annuities

Simple types of annuities that deliver exactly what’s needed by those who worry about running out of money in retirement: insurance payouts that will last as long as they do.  (Dreamstime/Tribune News Service)
Simple types of annuities that deliver exactly what’s needed by those who worry about running out of money in retirement: insurance payouts that will last as long as they do. (Dreamstime/Tribune News Service)
By Carla Fried Rate.com

About half of Americans surveyed by the Aegon Center for Longevity said they worry about running out of money in their later years.

If that includes you, it’s time to take a deep breath and with an open mind consider buying an annuity. Not any annuity. We’re in agreement there are plenty of sketchy folks pushing way too expensive and confusing annuity products. But there are straightforward, simple types of annuities that deliver exactly what the worriers need: insurance payouts that will last as long as they do.

A new analysis by the Center for Retirement Research at Boston College finds that the insurance protection of basic annuities – guaranteed income if you do indeed live a long time – requires you have less money saved up at 65 than if you were to skip an annuity and rely on your savings to support you.

Annuities are insurance, not investments

In terms of solving lifetime guaranteed income needs, basic annuities are the second best option available. (Delaying Social Security to age 70 takes the top spot, given the higher benefit payout and the embedded inflation adjustment built into Social Security payouts.)

But sort of like your least favorite vegetable, annuities can be hard to swallow. For starters, annuities require a big one-time premium payment. After spending decades building up retirement savings, it can be hard to let go of $100,000, $200,000 or more to generate the guaranteed income stream you want. And there’s the added risk that just a few years after you fork over the premium, you die, effectively collecting only a small fraction in payments relative to the premium you paid.

That’s a real risk, of course. In fact, the research team at the CRR at Boston College confirms that annuities are, on average, not a great investment. They find that between 1986 and 2020, for every premium dollar paid, people recoup about 80 cents in payouts.

But that analysis is sort of beside the point. Annuities aren’t an investment. Annuities are insurance protection.

The insurance case for annuities

When we pay the auto insurance premium, the home insurance premium and the term life insurance premium, we do so with the explicit hope we will never collect a penny on those policies. Right? But we have those policies as protection just in case something goes wrong.

With an annuity, you buy the same protection, but it’s actually for the risk of something going very right: You live a long life. Annuities are insurance if you are worried that you may live so long that your 401(k) and IRA savings could run dry, or require you to take on more investment risk (stocks) to have a shot at generating the income you will need.

The insurance payoff from annuities

Using average life expectancy data, annual annuity payout data, and interest rate data for each year, the researchers at the CRR at Boston College calculated an estimated dollar value for the insurance an annuity provides.

They focused on how much money someone age 65 would need to live as well, with or without an annuity. In the model, if there was no difference, the relationship would equal 1.00. But across a variety of types of annuities – more on this in a sec – they found that someone who bought annuities needed less wealth at 65 than someone who didn’t buy an annuity, based on average life expectancy data.

The simplest type of annuity is called an immediate income annuity. You fork over a chunk of money at 65, or whenever you decide to retire, and based on your age and gender and interest rates at the time you buy, you lock in a guaranteed payout that will continue until you die.

The researchers assumed an immediate annuity was bought at age 65. The insurance value (wealth needed at age 65) was well below 1.00, meaning less wealth is needed if you annuitize. In 2019, for men, it was 0.824 and for women it was 0.844. Across all the years in the study, the equivalent wealth needed (compared to 1.0 for not annuitizing) was 0.86 for men and 0.91 for women.

An indexed annuity works very much like an immediate annuity, with an added feature that boosts the annual payout by a set percentage, to help you deal with inflation. The researchers assumed an indexed annuity with a 3% annual adjustment. In 2019, the wealth needed for 65-year-old men who bought an indexed annuity was 0.822 and for women it was 0.833 compared to the 1.00 needed if they didn’t annuitize. For the entire study period, the average for indexed annuities was 0.85 for men and 0.89 for women.

Another type of annuity, called a longevity (or deferred) income annuity, is custom made for the 60-somethings who have an inkling they might live well into their 90s (say, a parent who lived into their 10th decade). With a longevity annuity, you purchase the annuity at 65, but payments don’t start until much later, typically age 85. Given the risk you may die before age 65, the premium cost for a longevity annuity is typically much less than for an immediate income annuity where the payouts start at age 65. (The study presumes someone uses 20% of their age 65 wealth to buy a deferred annuity.)

The deferred annuity delivers the biggest insurance value: In 2019 the wealth needed at age 65 is 0.76 for men and 0.72 for women. Across the entire study period, the average wealth needed if you bought a deferred annuity at 65 was 0.77 for men, and 0.73 for women.

All of that analysis assumes average life expectancy at age 65. The data the CRR used gives a 50% probability that a 65-year-old woman in 2020 will be alive at age 85 and a 65-year-old man has a 50% probability of being alive at age 85. If you aren’t a smoker and are in good health, your average life expectancy will be even longer.

And if you’re worried about running out of money, an annuity to complement your Social Security might deliver valuable peace of mind.

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