By Mark Miller
CHICAGO Aug 19 Economists have long argued that there's a perfect financial product for retirement: the humble immediate income annuity.
It's a straightforward proposition: Fork over a big chunk of cash to an insurance company, which starts sending a monthly check when you retire - or later. The cash keeps coming as long as you live.
The immediate annuity, which also goes by the name of single premium income annuity (SPIA), offers effective protection against longevity risk, which is the risk of outliving your money. It comes with an intriguing special sauce, euphemistically known as the "mortality credit." That simply means insurance companies use the unpaid assets of folks who die at younger ages to pay out to those who live longer, and it allows an annuity to have comparatively high payout rates.
For example, a 65-year-old male currently can buy a $100,000 annuity with a payout rate of 6.72 percent, according to New York Life.
But economists also talk about an "annuity puzzle." Namely, if SPIAS are such a perfect retirement vehicle, why do so few people buy them? Sales totaled $7.7 billion last year, according to LIMRA, the insurance industry research and consulting group. That's a drop in the bucket compared with IRAs and workplace retirement plans, where $5.3 trillion were invested last year, according to the Investment Company Institute.
Not much has changed this year. Sales figures released on Monday by LIMRA show that $3.4 billion in immediate annuities were sold in the first half of this year, down a bit from the same period of 2012, when sales totaled $3.7 billion.
One oft-heard response to the annuity puzzle is that retirees fear a SPIA won't pay off if they don't live very long. Another big objection is the loss of liquidity associated with an annuity purchase. What happens if you get really ill, or lightning cracks your roof in half?
Now, that fear is getting a close look in a study by two economists, who attempted to quantify what happens to the value of an immediate annuity when an unexpected health shock occurs.
The economists, Felix Reichling of the Congressional Budget Office and Kent Smetters of the Wharton School of Business, found that health shocks can produce a unique double-whammy for annuity buyers: a sharp decline in life expectancy, which cuts the remaining value of the annuity, and the unmet need for cash to pay for care. They conclude that for risk-averse retirees, or for those with limited retirement assets, the best move is to avoid annuities altogether.
Reichling and Smetters relied on Monte Carlo-style probability modeling to arrive at their conclusions, and their paper already has stirred predictable industry criticism over their assumptions and economic modeling. "Proving that people like liquidity is the ultimate 'duh' moment, says Matt Grove, senior managing director at New York Life. "We know that from our own research."
The research by Reichling and Smetters appears at a time when the Obama administration has been pushing for regulatory changes that would encourage the addition of annuity options in workplace plans - specifically, a little-used form of annuity known as a longevity policy. These are deferred annuities that can be bought well ahead of retirement with payouts delayed to an advanced age.
New York Life has had good success with a deferred income annuity product introduced in 2011, called the guaranteed future income annuity (GFIA). It's sold over $1 billion in premiums since July 2011 introduction. The GFIA allows a buyer to set a future date to start receiving income, pay an initial premium as low as $5,000 and then continue to make additional premium contributions along the way. The product is aimed at buyers in their 50s.
Proponents argue that income annuities protect not only against longevity risk, but the risk of under-spending in retirement.
A New York Life analysis of data from the University of Michigan and the Employee Benefit Research Institute found that roughly two-thirds of retirees who have $150,000 in savings at age 65 tend to spend no more than they receive from guaranteed income sources, such as Social Security and pensions.
"What this is telling us is that they are afraid to spend because they value the liquidity," Grove says. Conversely, he says, retirees who have purchased annuities or long-term care insurance policies, which protect against health shocks, make it possible for them to spend a bit more freely in the early years of retirement.
The questions about liquidity and health shocks raised by Reichling and Smetters may show the need for a different type of insurance product, argues Michael Kitces, partner and director of research for Maryland-based Pinnacle Advisory Group. "To me, the paper points to the value of pairing an annuity with a long-term care insurance policy," Kitces says. "A hybrid SPIA and long-term care product could be interesting."
Insurance companies - start your engines.