London Market Monitor – 31 August 2022
Our August review of the markets and Solvency II discount rates.
My dad and his dad both enjoyed secure retirements. They worked for organizations that provided a retirement plan that sent them a check every month for as long as they lived. I’ve worked for companies with no such plan. Like many other people these days, I was offered a 401(k) plan. My employers made contributions, I made contributions, and together those contributions have grown over the years with dividends and interest. Soon I will retire, but how can I make sure the money in my 401(k) plans will last for the rest of my life?
There are many suggestions and studies regarding how much you can “safely” withdraw each year, but they can’t guarantee that the money won’t run out before you die. You could live a miserly life to increase the likelihood that the money won’t run out. However, you don’t want to miss out on activities or opportunities that could enrich your life if you have sufficient funds. There is an alternative that is often overlooked and maybe even feared. You could take a portion of the funds you have saved and purchase an annuity, giving you a guaranteed monthly income just like my father and grandfather.
One complaint about annuities is that they are so complicated, but they don’t have to be. At its core, an annuity is an agreement with an insurance company. You would agree to make a premium payment to the insurance company of a specified amount, and the insurance company would promise to give you a specified monthly income until you die. You can also choose to cover your spouse or other beneficiary if you want, but the monthly payment will be a little smaller to pay for that extra coverage. Annuities can have other fancy guarantees and cool features, but those extra benefits come at a cost, increasing both the complexity and the price of the annuity. For this discussion, let’s consider simple annuities that pay a fixed amount for your life and may also cover your spouse.
The other primary complaint about annuities is that you may pay lots of money and then die “young” without receiving much in return. That is true, it could happen, but was your money just lost? Remember, an annuity is an insurance product. It works like health insurance. You might pay health insurance premiums and not get sick, and not need to see a doctor. Was it a waste? No, you still received the peace of mind that if something happened, you would get some financial assistance to see you through. It works like fire insurance. You pay fire insurance premiums with a hope that you never receive a single dollar back from the insurance company, as that is better than having your house burn down. What did you get for paying your premiums? Peace of mind, or an assurance that if something happens you can get some help, without being a burden on others.
In each case, the insurance company tries to find people that want to band together in a sort of brotherhood. You know someone in the group will get horribly sick and their treatment will cost a lot of money, but you don’t know who. Someone’s house is bound to burn down in a tragic accident or in a wildfire. You hope it isn’t you, but everyone in the insurance company’s “brotherhood” pitches in some money so that whoever is affected will be able to get some help when they need it.
The same is true with annuities. The insurance company brings people together. Some will live a long time, others just a short while, but you don’t know how long each person will live in advance. Nobody wants to run out of money because they lived a long time and all participants pitch in some funds to help the person(s) that ends up living longer. You might be the one that dies sooner, and the remainder of your money goes to help those that live longer, but you still have the peace of mind. You know that if you do live a long time, you will get that monthly payment until you die, and you won’t be a financial burden to your loved ones, or to society.
Well, that depends on how you look at it. There are more complicated annuities that provide a minimum amount at death. For the simple annuities spoken of here, the short answer is that no monetary payment will go to your heirs. That doesn’t necessarily mean they receive nothing. While it may be intangible, your heirs also receive peace of mind. They can make plans for their own lives, knowing that you will get a monthly check until you die. As long as that amount is sufficient, together with Social Security and other savings you may have, you won’t end up on their doorstep asking them to provide for your future.
This is a matter of personal preference. If you are retiring with a lot of money in your 401(k) and you have neither the expertise, nor the interest in investing it for the future, you may want to take the majority of your savings and convert it to an annuity that starts immediately at your expected retirement. Alternatively, you could take a smaller portion of your savings and purchase a “deferred” annuity that starts at age 75, 80, or 85. You will then know that your savings must last until the age chosen for annuity commencement. This can give you the best of both worlds, with flexible income in your early retirement years when you are more active, coupled with the added protection of guaranteed income in your later years.
Another way to think about when your annuity should start is through a frequently mentioned guide for insurance: You should insure the outcomes you can’t overcome on your own. I once had a toaster that burned up. It stayed on too long and ignited an expected tasty pastry. I had no insurance for the toaster, but that was ok because I could afford to buy a new toaster. If you decide to manage your own investments in retirement, and at age 70 it looks like you will be short of money, you could probably pick up some work to help make up the difference. If you are age 80 or 85 when you realize you will be short of money, what will your options be? You hope you are still healthy, both physically and mentally, but getting a job may not be realistic. It makes sense to insure against this outcome in some way, because you won’t be able to overcome that on your own.
For a given amount of money that will be used to purchase an annuity, the size of the resulting monthly income will be highly dependent on two things:
That’s a fair question, and you certainly want to purchase your annuity from a solid insurance company, but what if? Insurance companies are highly regulated and are required to keep a certain level of investments on hand to cover their liabilities. Government regulators will not wait until the money is completely gone to insist on some sort of change. If an insurance company is struggling, it could be that another company would step in and purchase them, taking over their assets and their obligations. In addition, each state has a “guaranty association” to protect annuity recipients if an insurance company fails. There are limits that vary by state. If your annuity is large you may not receive the entire payment, but you would have some protection. You could also reduce your exposure to a single insurance company by purchasing annuities from different insurers, and all your eggs wouldn’t be in one basket.
I have tried to explain the benefits of an annuity and dispel some common misperceptions about them, but should you buy one? That depends on a lot of factors, and you would be wise to consult with your tax, investment, and/or legal advisors. There are tax implications that are not covered here, and I don’t know what other options may be available to you personally. Still, if you want the peace of mind that your money will not run out, or want that assurance for your spouse, an annuity may be a great way to go. It is a little late for me to benefit from the type of retirement plan my father or grandfather enjoyed, but buying an annuity might be the next best thing.
Bruce Mitton is a consulting actuary at Milliman. The above material represents the opinion of the author and is not necessarily the view of Milliman. The ideas expressed are intended to show some of the benefits of purchasing an annuity, but all readers must evaluate their own situations and not rely on this material. Through publication of this information we assume no duty of liability to any reader, each of which is encouraged to seek the assistance of their own tax, investment, and legal advisors.