Understanding Annuities & Their Potential Role In Retirement Income

04.21.2015 | FPA Retreat

Michael E. Kitces MSFS, MTAX, CFP ®, CLU, ChFC, RHU, REBC, CASL Partner . Director of Research, Pinnacle Advisory Group Publisher . The Kitces Report, www.kitces.com Blogger . Nerd’s Eye View, www.kitces.com/blog Twitterer . @MichaelKitces, www.twitter.com/MichaelKitces

Handouts/Additional Materials at: kitces.com/FPARetreat

Understanding Longevity Annuities

• Defining A “Longevity Annuity” • An immediate annuity is a contract where the buyer exchanges a lump sum with an company to receive an ongoing stream of payments for life (or a certain period of time), generally starting within a year • A longevity annuity is a form of lump-sum-for-lifetime- payments contract, but payments do not begin until an advanced age • Also known as “ Deferred/Delayed Income Annuity ” (DIA)

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

1 Understanding Longevity Annuities

• Mortality Credits In Immediate Annuities • 25 people pool $1,000/person into an annuity

• Mortality rate: 1 person/year | Growth rate: 5%

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Mortality Credits In Immediate Annuities • Payments of $114.62/year/person add up over time!

Total Cumulative Payments from Annuity Pool $40,000

$35,000

$30,000

$25,000

$20,000

$15,000

$10,000 Cumulative Payments Cumulative $5,000

$0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Year

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

2 Understanding Longevity Annuities

• The Role Of Mortality Credits • “Everyone” is guaranteed payments of $114.62/year • Even though no one individually could sustain this!

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• The Role Of Mortality Credits • An individual who is afraid he/she “might” live for 25 years could only sustain a payment of $70.95/year! • Mortality credits allow for greater payments than what could be achieved alone!

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

3 Understanding Longevity Annuities

• The Role Of Mortality Credits • Mortality credits make it possible for “everyone” in the pool to get more than anyone could individually

• “Real world” mortality credits are even more back-loaded!

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Immediate Annuities Vs Longevity Annuities • What if the same group purchased the annuity, but none of the payments began until after the first decade?

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

4 Understanding Longevity Annuities

• Immediate Annuities Vs Longevity Annuities • Delaying payments… • Compresses principal & interest into fewer years… • And also accumulates more mortality credits!

COMPONENTS OF ANNUITY COMPONENTS OF ANNUITY PAYMENTS OVER TIME PAYMENTS OVER TIME $450 $450 $375 $375 $300 $300 $225 $225 $150 $150 ANNUAL PAYMENT ANNUAL

$75 PAYMENT ANNUAL $75 $0 $0 1 3 5 7 9 11 13 15 17 19 21 23 25 1 3 5 7 9 11 13 15 17 19 21 23 25 Principal Interest Mortality Credits Principal Interest Mortality Credits

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Immediate Annuities Vs Longevity Annuities • Waiting to just buy an annuity later would require a highly risky investment!

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

5 Understanding Longevity Annuities

• Increased “Returns” From Mortality Credits • With real-world mortality, each year of surviving has an exponentially larger contribution to return! Mortality Credits Age (basis points) 55 35 60 52 65 83 Source: Investment Benefits From Annuitization Assuming 70 138 40/60 Male/Female Split for Annuity 2000 Table Under 6% 75 237 Interest, by Moshe Milevsky, “Real Longevity Insurance With A 80 414 : Introduction To 85 725 Advanced-Life Delayed Annuities”. North American 90 1256 Actuarial Journal, 2005.

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Trade-Offs Of Delayed Vs Immediate Annuities • The longer the deferral period, the bigger the increase in payments!

Purchase Starting Monthly % Increase Age Payment Age Payment 65 65 $478.91 N/A 65 75 $934.18 95% 65 85 $2,656.20 455% (184%)

Source: Annuity Quotes via Cannex, as of July 8, 2014

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

6 Understanding Longevity Annuities

• Trade-Offs Of Delayed Vs Immediate Annuities • Not quite like a return, though, because waiting has a risk of not surviving, in exchange for higher payments if you do!

Annuity IRRs From Age 65 To 99 Annuity IRRs From Age 85 To 99 10% 6%

-10% 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 4% -30% 2% -50% 0% 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 -70% -2% -90% -4% -110% -6%

SPIA Longevity @ 75 Longevity @ 85 SPIA Longevity @ 75 Longevity @ 85

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Trade-Offs Of Delayed Vs Immediate Annuities • Cash refund guarantees ensure principal isn’t lost • But give up mortality credits in the process! Starting With Cash Purchase Monthly Payment Refund Age Payment Age Guarantee 65 65 $478.91 $471.45 65 75 $934.18 $929.46 65 85 $2,656.20 $2,373.19 Source: Annuity Quotes via Cannex, as of July 8, 2014

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

7 Understanding Longevity Annuities

• Trade-Offs Of Delayed Vs Immediate Annuities • Managing risk of death with a cash-refund feature • The longer the deferral, the more the impact!

8% Annuity IRRs (With & Without Cash Refund Guarantees) 6%

4%

2% SPIA (No Refund) 0% Longevity @ 85 (No Refund) -2% SPIA (Refund Guarantee) -4% Longevity @ 85 (Refund Guarantee)

-6% 85 87 89 91 93 95 97 99 Age

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Trade-Offs Of Delayed Vs Immediate Annuities • Managing inflation risk and CPI adjustments

Inflation- With Cash Starting Original Purchase Adjusted Refund Payment Monthly Age Monthly Guarantee Age Payment Payment (Also) 65 65 $478.91 $318.18 $308.37 65 75 $934.18 $710.39 $688.94 65 85 $2,656.20 $2,170.43 $2,005.07 Source: Annuity Quotes via Cannex, as of July 8, 2014

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

8 Understanding Longevity Annuities

• Trade-Offs Of Delayed Vs Immediate Annuities • But inflation adjustments only apply during the payout period!

$100,000

$90,000

$80,000

$70,000

$60,000 Deferral $50,000 Payment Period Period $40,000 Inflation $30,000 NO Inflation Adjustments $20,000 Adjustments! Guaranteed!

$10,000

$0 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 Age

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Longevity Annuity Inflation Risk During Deferral $120,000

$100,000 Longevity Annuity Income @ 4% Actual Inflation @ 4% Longevity Annuity Income @ 2% $80,000 Actual Inflation @ 2%

$60,000

$40,000

$20,000

$0 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 Age

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

9 Understanding Longevity Annuities

• Longevity Annuities And Bucketing Strategies • Can longevity annuities solve the “Unknown Time Horizon” problem of traditional DC plans?

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Longevity Annuities And Bucketing Strategies • Can longevity annuities solve the “Unknown Time Horizon” problem of traditional DC plans?

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

10 Understanding Longevity Annuities

TIPS Length Real Real Req'd Lump • Longevity Annuities And (Years to Yield Maturity Sum Payment Maturity - N) (I/Y) Value (FV) (PV) Bucketing Strategies 1 -0.50% $30,000 ($30,150.15) 2 -0.44% $30,000 ($30,263.32) 3 -0.37% $30,000 ($30,339.13) • 20-year bucket 4 -0.31% $30,000 ($30,377.34) 5 -0.25% $30,000 ($30,377.83) can be guaranteed 6 -0.04% $30,000 ($30,063.08) 7 0.18% $30,000 ($29,624.71) via TIPS ladder? 8 0.20% $30,000 ($29,516.44) 9 0.23% $30,000 ($29,394.88) 10 0.25% $30,000 ($29,260.21) 11 0.29% $30,000 ($29,049.88) 12 0.34% $30,000 ($28,816.41) 13 0.38% $30,000 ($28,560.38) 14 0.42% $30,000 ($28,282.46) 15 0.47% $30,000 ($27,983.33) Source: TIPS 16 0.51% $30,000 ($27,663.76) Yield quotes via the 17 0.55% $30,000 ($27,324.52) U.S. Department of 18 0.59% $30,000 ($26,966.45) the Treasury as of 19 0.64% $30,000 ($26,590.43) 0.68% $30,000 ($26,197.34) August 6, 2014 20 Total Cost of 20-Year Tips Ladder: $576,802.04 Cost Of Longevity Annuity: $208,000.00 Remaining Portfolio Reserves: $215,197.96

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Longevity Annuities And Bucketing Strategies • A comparable lifetime immediate annuity would cost $786k • Similar cost, but more flexibility & liquidity (and death benefit?)

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

11 Understanding Longevity Annuities

• Longevity Annuities Vs Alternative Choices • Superior to a purely fixed-income portfolio • “Expensive” to buy government bonds in low-yield environment • Mortality credits can always provide superior payments to comparable bonds alone… • At least for those most concerned about longevity • Solves the “Unknown Time Horizon” problem • Especially pernicious for laddered bonds if clients outlive the ladder!

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Longevity Annuities Vs Alternative Choices • Arguably dominates 8% Annuity IRRs (With & Without Cash Refund Guarantees) 6% immediate annuities 4%

• Superior in actual 2%

longevity scenarios… IRR 0% SPIA (No Refund) -2% • And greater liquidity Longevity @ 85 (No Refund) -4% during the intervening -6% 85 87 89 91 93 95 97 99 years! AGE • Even with a risk of “total” loss, it’s only a small slice!

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

12 Understanding Longevity Annuities

• Longevity Annuities Vs Alternative Choices

12% • Still IRR of Social Security Delay 10% Vs Longevity Annuity absolutely 8% dominated 6% 4%

by Social 2% IRR

0% Security! 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 -2%

-4%

-6%

-8% Delayed Social Security Longevity Annuity

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Longevity Annuities Vs Alternative Choices • Should Longevity Annuities replace fixed income, or stocks?

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

13 Understanding Longevity Annuities

• Longevity Annuities Vs Alternative Choices

Rolling Historical Returns Over 20- & 35-Year Time Horizons vs. 5.4% Longevity Annuity Hurdle Rate 18.0% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 1871 1875 1879 1883 1887 1891 1895 1899 1903 1907 1911 1915 1919 1923 1927 1931 1935 1939 1943 1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991

Hurdle Rate 20-Year Rolling 35-Year Rolling

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Longevity Annuities Vs Alternative Choices

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

14 Understanding Longevity Annuities

• How Longevity Annuities Stack Up

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Longevity Annuities As An Accumulation Vehicle? • Buying incrementally during the accumulation years? • Value again depends on the time horizon • Superior to accumulating in bonds for future spending • Inferior to accumulating in stocks for future spending? • Mortality credits not very significant during the early accumulation years anyway?

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

15 Understanding Longevity Annuities

• Caveats And Concerns • Relies heavily on the credit quality of the insurer • Check credit quality of the insurer • Could greater volume of longevity annuities increase insurance company risk in the future? • The danger of longevity/health “shocks” • Difficult to liability-match “back-loaded” payments?

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Caveats And Concerns • The “best” longevity annuities take the greatest risk? • Risk of loss is what gives the mortality credits • Buying refund guarantees eliminates the risk, but also much of the mortality benefit? • Manage risk by limiting exposure, not buying death benefit guarantees?

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

16 Understanding Longevity Annuities

• Caveats And Concerns • Are interest rates and longevity annuity payments just “too low” to lock in now? • Limited pricing competitiveness from companies • Or just conservative pricing given risks to the insurance company? • Regulatory or longevity changes could make pricing worse , not better?

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Caveats And Concerns • The potential “cost” of waiting… $25,000 Annual Income from Longevity Annuity

$20,000 versus an Immediate Annuity

$15,000

$10,000 Annual Annual Income

$5,000 Note: Immediate Annuity purchased w/ $- $100k growing at 1.5% 70 75 80 85 Payment Starting Age Longevity Annuity Immediate Annuity

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

17 Understanding Longevity Annuities

• Caveats And Concerns Impact of Waiting for a Longevity Annuity & The Cost of Foregone Mortality Credits – Increases Required Just to Break Even 10.0% 250%

8.0% 200% 6.0% Cumulative Increase

4.0% 150%

2.0%

100% 0.0% Annual Increase Annual 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 -2.0% Age 50% -4.0% Annual Increase Cumulative Increase -6.0% 0%

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Taxation Of Longevity Annuities – After-Tax Dollars • Normal exclusion ratio still applies • Principal still amortized over payout period

$140,000 $100K PREMIUM = $500/MONTH PAYMENTS $120,000 Immediate Annuity $100,000

$80,000

$60,000

$40,000 Cumulative Payments Cumulative $20,000

$0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 22.2

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

18 Understanding Longevity Annuities

• Taxation Of Longevity Annuities – Qualified Dollars • Funds out of retirement accounts taxed “normally” • Longevity annuities may defer past age 70 ½ • “QLAC” rules meant to alleviate this conflict • Limited to lesser 25% of any plan (IRAs aggregated) or $125k total across all accounts • Must begin by age 85, no surrender value • Indirect “incentive” to buy inside retirement accounts? • But still has risk if you don’t live to 85!?

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Planning Implications/Applications • Of primary importance for those who fear outliving their life expectancy • Delaying Social Security always superior first step • Arguably dominant over immediate annuities • Solves the “Unknown Time Horizon” problem • Can be purchased with inflation protection • Still may be inferior to long-term equities though?

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

19 Understanding Longevity Annuities

• Planning Implications/Applications • Difficult to peg “right” amount to purchase • Depends on uncertainty of inflation during deferral? • “Best” versions have fewest death guarantees? • Limits the amount of capital required while maximizing the payouts if client survives • Maximize the deferral period! • But this poses the greatest psychological challenges?

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Understanding Longevity Annuities

• Planning Implications/Applications • An uphill battle to playing the waiting game • Potential for competitiveness to increase… • Against foregone mortality credits, and the risk that payouts get worse (regulatory or longevity changes) • Could become highly compelling at higher payout rates, though? • Buy from a top-rated insurer! • Not a time to shop on payment size alone!

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

20 Understanding Longevity Annuities

• Summary • Longevity annuities provide an interesting possibility • Solves the “Unknown Time Horizon” problem • Risks implicitly managed by smaller required payments • Compelling now against some alternatives… • ..But the time may not be right just yet for widespread use?

Handouts/Materials: kitces.com/FPARetreat @michaelkitces

Questions? Handouts & additional materials: www.kitces.com/FPARetreat

Contact: [email protected]

@michaelkitces

21