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Good and Bad Reasons to Pass Up an Immediate Annuity

As an actuary, I'm acutely aware of the risks that retirees face with drawing down 401(k) and other retirement savings. I believe that an immediate annuity is a good tool to manage longevity risk--the risk that you'll live too long and outlive your assets.

Yet according to the 2010 Retirement Confidence Survey (RCS) recently released by the Employee Benefit Research Institute, just 14 percent of retirees reported that they had purchased an annuity, and only 11 percent of workers indicated they are very likely to purchase an annuity. When asked why they elected not to consider an annuity, by far the most frequent response was that they couldn't afford it (reported by 26 percent of workers and 24 percent of retirees).

This is a puzzling result, because an immediate annuity has the potential to produce higher lifetime income compared to simply investing and drawing down your retirement savings. There are two possibilities for what's really happening among people who say they can't afford an annuity.

  1. They don't have enough savings to generate a meaningful income with an annuity, which is understandable given the current level of retirement savings (for details see my post Can't Retire Yet? Don't Despair).
  2. Most people are unaware of the large amount of money that it takes to generate a lifetime income. Examining the purchase price of an annuity is a cold dose of reality, and denial can be a common result.
Let's dig deeper on this second point. To see what I mean, let's look at the example in Kathy Kristof's post Income for Life: 7 Best Annuities. She looked at seven insurance companies, and found that the highest lifetime income for a 70 year-old man generated by a $100,000 purchase price was $744 per month. "That's all? I need more than that to live on" is a common response I hear when people look at the costs of immediate annuities, followed by "I can do better myself." While you might think that "doing better myself" means getting a better investment return, in reality "doing better myself" usually means that they will withdraw more each month from their retirement savings.

Drawing more per month has a high chance of "ruin"--which is actuarialese for "you're broke and not dead yet." Let's do the math to see why. For a 70 year-old man, many financial advisors and actuaries would suggest a 5 or 6 percent annual withdrawal rate from retirement savings; these withdrawal rates produce odds of ruin of one out of ten or lower, which might be acceptable odds for many people. Applying these withdrawal rates to $100,000 results in monthly incomes of $417 to $500--much lower than $744 per month from the annuity. In effect, the annuity is providing an annual payout of 8.9 percent (that's $744 times 12, divided by $100,000). I did extensive Monte Carlo analyses for my book Live Long & Prosper!, and I estimated that a 9 percent withdrawal rate for a 70 year-old man has odds of ruin of roughly 40 percent--not much better than flipping a coin. That's too high for me, given the unpleasant consequences of outliving your money.

Turning back to the 2010 Retirement Confidence Survey--some other bad reasons cited for not considering an annuity were:

  • Not knowing enough about the product (12 percent of workers, 3 percent of retirees).
  • Feeling they could do better managing the money themselves (10 percent of workers, 4 percent of retirees).
  • Not knowing it was an option (5 percent of workers, 9 percent of retirees).
  • Not trusting or believing in them (8 percent of workers, 2 percent of retirees).
  • Lack of interest (6 percent of workers, 4 percent of retirees).
In my view, the only good reason reported in the RCS for passing up the immediate annuity was "already having a pension, investments, or income," cited by 13 percent of workers and 15 percent of retirees. You don't need an immediate annuity if you have a substantial pension from work, or if your retirement savings are large enough to generate a sufficient retirement income either by living off the investment income or with prudent withdrawals of principal (i.e. Bill Gates doesn't need to buy an annuity).

"Annuity" is a dirty word in many circles, usually due to the high costs and mediocre performance of deferred annuities, or by complicated features that some insurance companies attach to immediate annuities. But a simple, low-cost fixed immediate annuity is a different animal that doesn't deserve this reputation. I suggest that an immediate annuity deserves serious consideration for people who have significant retirement savings and are concerned about managing their longevity risk. For more details on drawdown strategies for your savings, see my prior post Make Your Money Last For Life. In a future post, I'll cover the pros and cons for considering a variable immediate annuity, which has the potential for providing a lifetime income and protection against inflation.

Image from iStockphoto contributor kycstudio

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