It’s become difficult in recent years to say anything new and interesting about annuities.
That’s because the debate about annuities’ place in retirement finance has become increasingly polarized, generating lots of heat but little light. Edward McQuarrie nevertheless has made the attempt: In a just-released study, he has uncovered a number of useful and little-known insights that we would do well to take into account when considering annuities. McQuarrie is professor emeritus at the Leavey School of Business at Santa Clara University.
It’s important to note at the outlet that McQuarrie is anything but doctrinaire about annuities. He neither believes they are appropriate for all retirees nor thinks they should be avoided at all costs. His motive in conducting his new study, he told me in an interview, was—by asking hard questions—to find annuities’ “highest and best use.”
Retiries are encouraged to read McQuarrie’s lengthy study for a full discussion of what he found. Below is a summary of a few of his conclusions that are not currently included in most discussions of annuities.
Buying annuities is a gamble too
Most insurance companies sell annuities by emphasizing that we don’t want to run out of money before we die. Why gamble with the prospect of dying broke?
This is a compelling sales pitch, to be sure. But, McQuarrie reminds us, annuities involve a gamble too: That you won’t die before you reach your life expectancy and thereby forfeit a substantial portion of your wealth to the insurance company.
Insurance companies recognize the existence of this alternate gamble, and have created annuities that return a portion of your initial investment to your heirs if you die within the first few years after purchase. (Unfortunately, the payout rates from annuities with such a guarantee are smaller.) While this kind of annuity deals with the possibility you get hit by a truck after walking out of the insurance company office, it doesn’t completely eliminate the gamble you take when purchasing an annuity.
Another way of thinking about the gamble inherent to annuities is whether you want to leave the remainder of your portfolio to your heirs or to the insurance company. McQuarrie explores what would happen if you took the amount you’d otherwise use to purchase an annuity and instead invest it in a bond portfolio and simply take Required Minimum Distributions (RMDs) according to the IRS schedule. He shows that, even when you die at your expected life expectancy or even exceed it by a few years, there is a not inconsiderable chance that your portfolio will still be worth a substantial amount.
How important is it to you that, in such a case, your heirs inherit that amount?
The risk of outliving your money is exaggerated
There’s no right or wrong answer to this question. But it leads into the second of McQuarrie’s findings: The risk of outliving your money may be exaggerated.
To show this, McQuarrie imagined what would happen if, instead of purchasing an annuity, you invested the amount in T-bills at their current yield of next to zero and each year withdraw an amount equal to what you would otherwise receive from the annuity. Believe it or not, according to McQuarrie, this non-annuity approach wouldn’t run out of money for 20 years. Only a small minority of retirees live past their early 90s.
Note furthermore that McQuarrie’s example is a worst-case scenario, since no one would invest their entire retirement portfolio in T-bills earning nothing. When investing in a long-term Treasury with even a modest coupon, the non-annuity portfolio almost always remains solvent for longer, with a correspondingly smaller probability of running out of money before age 100.
Annuities front-load withdrawals—a potentially major advantage
One little-appreciated feature of annuities is that, in the first few years after purchase, their annual payments will exceed what you could otherwise get if you invested the same amount in a government bond and withdrew each year your IRS-specified RMD). This situation most likely reverses itself after a number of years—15 years or so—when RMDs from the bond portfolio will start exceeding what the annuity would pay.
As a result, the net present values of these two payment streams will be similar. So from the perspective of your entire retirement the two will often be a wash. Nevertheless, this front-loading of payments that you get from an annuity is a potentially big advantage. Retireees often want to splurge on things like travel in their first years postretirement, when they can most enjoy doing so, yet taking extra amounts out of your bond portfolio would be risky since doing so would increase the odds of prematurely exhausting your funds.
McQuarrie argues that this front-loading feature could very well be the most important reason to annuitize rather than self-finance your retirement. “Acceleration of income, not its prolongation, would be the key benefit provided by a life annuity.”
Annuities are more compelling when bond yields are low
Another little-known feature of annuities that McQuarrie focuses on is that their advantage over an otherwise comparable bond portfolio is greatest when bond yields are low. That’s because each year’s annuity payment includes a return of principal. The portion of each year’s payment represented by this return of principal will therefore be greatest when bond yields are lowest.
This is important to keep in mind because many who would otherwise purchase an annuity have been discouraged from doing so because annuity payout rates—which are correlated with bond yields—have come down over the last decade as interest rates have declined. They think—mistakenly as it turns out—that they should wait to purchase an annuity until bond yields (and therefore annuity payout rates) return to their glory days of old. However, if we were ever to return to those days, annuities would be a less-compelling alternative.
That’s because, according to McQuarrie’s calculations, it’s easier for a bond portfolio to beat an annuity when interest rates are high. By waiting until interest rates go back up to levels seen in previous decades, therefore, potential annuitants may therefore be shooting themselves in the foot. Even worse, if in the meantime they are invested in bonds, their portfolios would lose a lot of money while waiting.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected],
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