Wharton Financial Institutions Center

Policy Brief:  Personal Finance

Investing your Lump Sum at Retirement

David F. Babbel

Fellow, Wharton Financial Institutions Center

Professor of Insurance and Finance

The Wharton School, University of Pennsylvania babbel@wharton.upenn.edu

 

Craig B. Merrill

Fellow, Wharton Financial Institutions Center

Professor of Finance and Insurance

The Marriott School of Management, Brigham Young University

Merrill @byu.edu

First Draft: June 10, 2006

This Draft: August 14, 2007

This essay is based, in  part, on a study by  the same  authors entitled “Rational Decumulation,” Wharton Financial  Institutions  Center  Working  Paper  #06-14,  May  2007.  That  study  was  co- sponsored  by  the Wharton  Financial  Institutions  Center  and  New York  Life  Insurance  Company. The usual disclaimer applies.

Introduction

Imagine sitting down on the day of your retirement to plan your financial future. You know what your annual expenses have been and you want to maintain your current standard of living. So, you consult a recent  mortality  table  and  find  that if  you’ve  made  it  to  your  65th   birthday,  you  can  expect  to  live  to  85 years old.  You  perform  a  little  calculation  and  find  that,  together  with  your  Social Security  monthly  payments,  you  have  just  enough  savings  to  maintain  your current  standard  of  living  and  spend  al   of  your savings and future expected earnings by the time you die at the age of 85.  But, what if you live longer? Will you be reduced to eking out an existence on Social Security alone? Where will the additional money come from? What if future investment returns are not what you anticipated at the start of your retirement? These questions are increasingly urgent in America today, as forces are combining to make planning for outliving your resources more important than it has been in the past. Old rules of thumb for spending   your   assets   in   retirement,   called   decumulation,   need   to   be reconsidered.

The Perfect Storm

Retirees must take strategic action in the deployment of their accumulated savings and funds as they begin retirement. Five forces are converging upon Americans in what some have called the Perfect Storm – others the Tsunami Wave – that is about to engulf us from al  sides.1  The best we can do is to organize our own finances in such a way that we can provide for ourselves, because there isn’t anything we can do to stop these converging forces. These five forces are:

1)  The  decreasing  levels  and  importance  of  Social  Security  benefits.

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Relative to the benefits provided to our parents, people currently in their working years will receive a much lower return on their Social Security contributions.   As can be seen in the chart below, the implicit rate of return on contributions was far higher for earlier beneficiaries. [Source: Social Security Administration.]

The  adverse  effect  of  this  lower  rate  of  return  especial y  impacts  the  higher contributors,  as shown below. This chart shows that people who had the lowest earnings levels are projected to receive a rate of return on  their   contributions   of 2.8%,  seven  times  higher  than  0.4%  returns  that  are projected  for those whose earnings were taxed at the maximum levels. However, the rates of return for both groups are very low. [Source: Social Security Administration.]

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2)  The demise of defined benefit (DB) pensions. Over the past 15 years, there has been only one new pension program of any size initiated in the U.S. The number of pension plans in the U.S. peaked at 175,000 in 1983, and has since declined to less than 25,000. While much of the reduction was due to the elimination of small and medium plans, some of the largest pension programs have also been discontinued,  closed  to  new  membership,  or  frozen  to  all  employees.  About 30%  of  the  remaining  pension  programs plan to do close within the coming two years.2 Many of those that still  remain are insolvent or otherwise  under funded,  and the  government’s  Pension  Benefit  Guarantee  Corporation  (PBGC)  is  reeling under a load it cannot sustain. During the same time period, 401(k) defined contribution  (DC)  plans  in-creased from around 17,000 to over 450,000. When al defined contribution type plans are included, there are over 650,000 today. While the reasons for the substitution of DC for DB plans are complex and cannot be covered here, suffice it to say that there is a dynamic change going on in response to various economic factors and government initiatives that will change the way we cope with retirement income needs. Over time, the problem is bound to get worse.

The economic implications for the average individual are significant. Under a traditional pension program, the retiree receives a set monthly income for as long as he or she lives. Under a defined contribution program, such as a 401(k) or 403(b) program, the amount of income you collect after retirement and how long you continue to receive it is anyone’s guess. There are no guarantees. In effect, the risk of retirement has been shifted away from the employer and the PBGC that insures the pension benefits, and placed upon the shoulders of the employee.  Put  another way,  the  financial  risk  of  retirement  has  been transferred  from  those  best  able to  bear  it  to  those  less  knowledgeable  and  least  able  to  bear  it.  In the past, annuitization (discussed below) was less important, as pensions were combined with Social Security and handled most of our retirement needs. But today, as pension benefits are gradually (and at times, suddenly) eliminated, and as Social Security benefits  stagnate,  and  are  sometimes  reduced  through  delayed  eligibility  and taxation, annuitization becomes a much more important retirement strategy.

3)  The aging of the baby boom generation.  Beginning  last  year,  the  first  members  of the  largest generation  in  American  history  turned  60,  leaving  their  jobs  and entering  the  retirement  force.  The “boomers,”  as  this  generation  is  commonly known  (born  from  1946  to  1964),  will  continue  to  exit  the workforce  for  at least  another  twenty  years.  Currently constituting over 27% of the U.S. population and 47% of all households, they will become dependent upon Social Security, retirement plans, and any accumulated assets.

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4)  The emergence of post boomers. Generations X (born between 1965 and 1979) and Y (born between   1980   and   2001)   will   be   burdened   not   only   with   the responsibility  of  providing  for  their  own  future retirement  and  health  needs,  but also  with  supporting  the  Social  Security  and  Medicare  costs  of  the boomers. The net effect of this is that there will soon be many more people draining funds from the Social Security system, with far fewer people contributing to it.

5)  The increasing longevity of the American population. In the table below, we show how the life expectancy  for  the  population  at  large  has  increased  over  the  past century.  While expected lifetimes are longer in all categories, the life expectancies for people who reach age 65 are the most relevant for our analysis.

An examination of the table shows that since Social Security began monthly payments in 1940, the number of months we can expect to receive benefits for those of us who reach age 65 has increased by roughly 50% for men and women. Coupled with the fact that when Social Security was instituted, the average  person  did  not live to age 65, increased longevity has placed a tremendous burden upon the retirement system.  It should be kept in mind when reviewing this table that these are life expectancies for the population at large. For people who reach age 65 in good health, the life expectancies are currently about four years longer than shown, and remember that half of those people will live longer, many much longer. When considered together with the decreasing yields from bonds and lower returns from stocks in recent years, these forces spell disaster for those who do not take more prudent financial measures to prepare for what is becoming the major financial risk of the 21st century: living too long.

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So there you have it.  The  decreasing  rates  of  return  on  our  Social  Security contributions,  the accelerating   demise   of   defined   benefit   pensions,   combined with  the  advent  of  America’s  largest generation  in  history  now  approaching retirement,  their   longer   expected   lifetimes,   and   the   much smaller relative population  of people who  are going to be  asked to support their unfunded benefits – taken  together  we  have  all  the  necessary  ingredients  for  the  perfect storm  – with  a  few extra  ingredients thrown in for bad measure!

What is Annuitization?

Lifetime  income  annuities, sometimes  called  life  annuities,  income  annuities, single   premium immediate   annuities,   or   payout   annuities,   involve   large insurers pooling  people  of similar  age  and sex, with each person giving to the insurer an amount that will generate sufficient returns to provide them   with   a monthly income throughout their expected lifetimes. Those who die before reaching their  life  expectancy  are,  in  effect,  insuring  those  who  live  beyond their  life  expectancy.  In  essence,  it  is  the  opposite  of  life  insurance,  where the  payments  of  those  who  remain  living  go  to cover the benefits paid to the estates of those who die prematurely. In the case of life annuities, the risk of outliving one’s income is pooled among all annuity purchases, providing a kind of insurance against outliving one’s assets.

If, at retirement, people plan their finances to cover their economic needs throughout  the  remainder of their expected  lifetime, which  is roughly until  age 86,  half  of them  can  be  expected  to fail.  This is simply because half will live longer and many much longer, than their life expectancy. (See chart below.)

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However,  if  they  choose  a  life  annuity  instead,  they will  be  able  to spend  at  the same rate,  but be  covered  for  as  long  as  they  live.  A  life annuity  is  the  only  investment  vehicle  that  features  this advantage.  Trying to  replicate  this  advantage  of  a  secure  lifetime  income,  but  without  the risk-pooling  of  a  life  annuity, will  cost you  from  25%  to  40%  more  money, because you would  need  to set  aside  enough  money  to  last  throughout your entire Possible lifetime,   instead   of simply   enough to last   throughout   your expected  lifetime.  Even  at  this  higher  cost,  you  cannot  be  sure  you  will achieve  a secure  lifetime  income,  because  interest  rates  could  change  over the  next  30-50  years while you are in retirement. (We will discuss this later.)

Economists’ Views of Decumulation

George  Bernard  Shaw  once  quipped,  “If  you  laid  all  the  economists  end to  end,  they  still  wouldn’t reach  a  conclusion.”  Well,  that  time-honored  adage has   changed,   at   least   in   one   area,   because   economists have come to agreement from Germany to New Zealand, and from Israel to Canada, that annuitization of a substantial portion of retirement wealth is  the best way  to go. The list of economists who have discovered this includes some of the most prominent in the world, among who are Nobel Prize winners. Studies  supporting  this  conclusion have  been  conducted  at  such  heralded  universities  and  business schools  as MIT, The Wharton School, Berkeley, Chicago, Yale, Harvard, London Business School,  Illinois,  Hebrew  University,  and  Carnegie  Mellon,  just  to  name  a  few. The value of annuities in retirement seems to be a rare area of consensus among economists.

A recent National Bureau of Economics study, which appeared in the prestigious American Economic Review, demonstrated under much more plausible conditions than had ever been supposed, that full annuitization was optimal for people who had no desire to leave a bequest to their heirs or charitable organizations.3     It   also   concluded   that   for   those   with   bequest   motives, substantial  annuitization  of  retirement wealth was still  the most prudent way to act.

In another recent study, we re-examined the unique features of annuitization  and  showed  that  people  who  place  their  retirement wealth in mutual funds of stock, bonds, the money market, or some combination thereof are subjected to greater risk, often higher expenses, and  returns that  are  unlikely to  keep pace  with  annuity returns,  especially  when  risk  is  taken  into  account.  The recommendations from our study as well as existing academic models are below.

Recommendations

Like others before us, we found that substantial annuitization was generally prescribed by a sophisticated model of economic decision-making.  The  reason we  conducted  yet  another  study  of  this  was  to incorporate  several  degrees of  greater  realism  that  had  not  been  included  in  earlier  economic  models, and to re-examine the annuitization decision in this richer economic context.

The  level  of  annuitization  that  was  considered  optimal  depended  on a  number  of  factors,  such  as amount of wealth at retirement, level of Social Security  benefits  accrued,  tolerance  for  risk,  desire  to  leave  a     bequest, impatience  to  consume,  general  level  of  interest  rates,  expected  return  on stock,  and  stock market  risk  levels.  It  also  depended  on  marital  status,  age, and  whether  pension  income  was  being earned.

While we cannot present here all of the scenarios that were examined, we can give some general conclusions about what our study showed.

  1. You should  begin  by  annuitizing  enough  of  your  assets  so  that  you  can provide   for   100%   of   your minimum acceptable level of retirement income. Annuitization  provides  the  only  viable  way  to  achieve  this  security  without spending a lot more money. The economic models invariably attest to this fact – that the cost  of  not  being  able  to  cover  basic  expenses  far  exceeds  the potential   upside   of   taking   on   additional equity exposure. In calculating how much to annuitize privately, subtract from what is needed each month from the amount  you  will  be  getting  from  Social  Security  and  any  pension  benefits you  may  have  accrued.

Then annuitize a sufficient amount of your assets to provide for the remainder of the monthly income you will need to reach that threshold level.

  1. Next, our study shows that you will generally need to annuitize a significant portion of  your  remaining  wealth,  while  investing  the  balance  in  stocks,  fixed income securities, and money markets. The economic models of rational behavior, which weigh the riskiness of outcomes against a person’s tolerance for risk, all show that equities and fixed income are not substitutes for annuities, because they do not address the major risk we face of outliving our assets. For this reason, economists’  generally  considers  life  annuities  to  be  a  separate  asset  class. Equities and fixed income can be complements to, but cannot replicate nor substitute for annuitization. How much of the remaining wealth should go to life annuities will depend on the factors discussed below.

a) You will want to make provisions for any extraordinary expenses, such as uncovered health costs and institutional car These gaps in coverage can be purchased through  supplemental  health  and  long-term  care  insurance,  or perhaps from a rider to a life annuity that increases the payments beyond a certain age.   For   example,   suppose   that   you   receive   Social   Security benefits  of  $20,000  per  year,  and  life annuity  payments  of  $25,000  each year,  for  a  total  annual  income  of  $45,000.  If long-term institutional care costs around $70,000 per year, you will  need to get an annuity rider that doubles your annual annuity income to $50,000, to begin at the age when you are more likely to need institutional care. Taken together with your Social Security, you will reach the targeted income level. Since Social Security is linked to inflation, and the cost of long-term care is influenced by inflation, you may need to allocate a portion of your private annuity money to a contract that provides some escalation in benefits over time.

b) You will want to make provision for your heirs, but balance this provision against your own desire to live above your minimum acceptable living standard. Since the non-annuitized wealth is generally for your heirs, its present value is the same whether you give it to them now or later, because future benefits will be discounted by current Although   your   heirs   might   appreciate   it more  now,  at  least  it  is  not likely to go away if you live beyond your life expectancy,  owing  to  your  decision  to  annuitize  the  amount  of  assets necessary to provide you with a decent living, no matter how long you live.

c) Our study found, as have most other studies, that the greater the tolerance you have for financial risk, the higher the proportion of your excess assets – i.e., assets  that  are  not  needed  to  provide  for  your  minimum  acceptable standard of living – could be placed in stock or other risky inv We never found this level to be much above half of your excess assets. For example, if it takes 60% of your lump sum distribution at retirement, together with Social Security and any pension benefits, to provide the mini-mum level of income you will need, up to half of the remaining 40% of your assets can be placed in stock if you are exceedingly tolerant of financial risk.  In cases where individuals have lower tolerance for financial risk, the portion of excess assets that can be allocated to stock declines to 10% – 30% at age 65. In contrast, optimal annuitization of the excess assets ranges from 40% to 80%, and non- annuitized fixed income general y is 5% or less of your excess assets.

d) Remember, these generalizations depend on the size of bequest you wish to leave, as well as a host of other financial assum One of the assumptions used in the full study was a markup on life annuities of 10%, which is quite a bit higher than we have found in recent months. Today’s lower markups would justify even higher levels of annuitization.  Finally, we suggest that annuities be purchased only from the most financially sound insurance providers. You will be able to sleep a lot better!

Why Don’t More People Annuitize – Reasons and Excuses (or, Annuity Myths)

While  public  and  private  annuitization  (i.e.,  Social  Security  and  pensions) were  heavy  in  the  past, relatively  few  Americans  not  covered  by  pensions today  have  chosen  to  annuitize  their  wealth  through private annuity purchases. Given the alarming confluence of economic and demographic changes occurring today, the number of people choosing life annuities should be larger than ever.

Many  market  participants  believe  that  “stocks  for  the  long  run”  is  the  way to  go.4   But  our  study showed  that  over  the  long  haul,  unless  stocks  achieve excess   returns   above   Treasury   bonds   at   least twice as high as they are generally expected to generate, it often makes more sense to annuitize most of ones wealth at retirement.  So why don’t more people annuitize?  Here are some common myths about annuities.

  1. They cost too much!

The market for life annuities has become very competitive in recent years, and today the markups in price (“loadings” in insurance parlance) are very low for the people who actually purchase them. During the   past   decade,   these   markups above  actuarial y  fair  prices  have  come  down  from  around  6  –  10%  to less than half that level from the top companies, approaching zero in some cases.5 Of course, if you are unhealthy at 65, and have low prospects to regain your health, an annuity purchase may not be the way to go. However, you will be putting your own financial future at risk in so doing, because you really do not know what medical advances will occur, or how long you will live. Compare  the  0%  –  5% one-time  markups  on  life  annuities  with  the  1%  –  2%  annual  expense  ratios levied by typical mutual funds, as well as front-end or back-end loads that sometimes  reach  as  high  as 8%, and life annuities compare favorably. And don’t forget that life annuities, with their one-time markups, offer lifetime income security. In  contrast,  mutual  funds  offer  no  such  guarantees  against  outliving  ones assets.

  1. What if I get sick?

There are three ways to provide for hospitalization and nursing care costs that are not picked up by Medicare.  Supplemental  health  insurance  can  be  purchased that  covers  gaps  in  Medicare  coverage. Long-term care insurance can be used to supplement monthly income to meet the high costs of institutional care, which at the beginning of this decade had already reached an average of $70,080 a year for a private room and $61,685 for a semi-private room.6  The third way might be the least expensive of all, although it does carry some risk. Life annuities are now available that will increase monthly payments by up to 400% when the annuitant reaches a specific age, e.g., 85 years of age. The annuitant can choose an age when the need for institutional care begins to become more likely, and select the desired level of in-crease in payments. While annuities with   this   feature   cost more than regular annuities that provide level payments  throughout  life,  they  can be  well  worth  the  extra  cost.  The risk is that you might need institutional care before the higher income begins at age 85. If, on   the other hand, your need doesn’t arise by age 85, count your blessings and use the extra income for something else, or save it for a rainy day. Other innovative life annuities allow you to withdraw as much as 30% of your future payments at five-year intervals, or in case of losses because of a fire, flood, or other natural disaster.

Yes, some of these provisions cost extra money, but you can pay for them now, or pay later at perhaps much higher prices. None of them are really excuses for not annuitizing a substantial proportion of your remaining wealth at retirement.

  1. What if inflation returns? Won’t my fixed payments become worth less?

Life annuities have evolved considerably over the past several years to address this problem. Today a retiree can elect to have his or her monthly payments increase at rates ranging up to 6% per year. Alternatively, inflation-linked life annuities can be purchased. Both kinds of inflation protection entail receiving lower initial payments, but they grow over time. Indeed, annuities are now available that make it possible to achieve a wide range of income patterns over one’s remaining lifetime, to address different economic needs.

Investment horizon requires lower, not higher, allocations to risky assets. See Eric Jacquier, Alex Kane and Alan J. Marcus, “Optimal estimation of the risk premium for the long run and asset allocation: A case of compounded estimation risk.” Journal of Financial Econometrics, Vol. 3:1 (Winter 2005), 37-55.

  1. Isn’t it  cheaper  to  use  some  sort  of  homemade  strategy  that  mimics the  behavior  of  life annuities? That way I can cut out the insurer!

This would be nice, but it is a fantasy. We don’t notice people doing this with life insurance. Why not? Because it takes an insurer to assemble a large pool of thousands of people to fund the payments that go to people who die prematurely. A large pool is also needed to provide predictability and efficient pricing to the provider of insurance, as well as to the consumer. The same pooling principle is behind life annuities, and allows insurers to offer monthly payments throughout your life, no matter how long you live. It is difficult to form a viable pool size if you try this at home on your own!

That hasn’t stopped financial economists from experimenting with close to a dozen different investing and  budgeting  plans  to  see  if  mimicking  the  desirable attributes  of  life  annuities  can  be  done  successfully.7    Thus  far,  each  one exposes   the   retiree   to   the   possibility   of   suffering   sustained   periods   of inadequate   income,   at   times   even   below   survival   income   level.   Financial

planners sometimes say that a particular favored system may give you a good chance  of  significantly  higher  investment  returns  if  your  savings  are  placed  in equities or some other favored investment. That may be true. But such homemade systems  also  carry  a  risk  of  running  out  of  income  long  before  one  runs  out of  life.  Their sponsors may counter that the risk of such an eventuality, if everything goes according to assumptions and the plan is followed tightly, may be only 15%. That  is  roughly  equivalent  to  the  16.7%  odds  of  losing  in  a  game  of Russian roulette, and few people are prone to participate in such games! Why, then, are people so prone to bet their own income security when it comes to retirement? And what if a particular scheme, by giving up a little of the upside, reduces the chances of failure to half that level? It is sort of like the comfort one receives  by  substituting  a twelve-shooter   with   eleven   empty   chambers   for   the   six-shooter.… We have calculated that under today’s interest rates, it would take from 25% to 40% more of your wealth to achieve the same secure level of income throughout your possible lifetime that you can get through annuitization. Yes, if you happen to die earlier, you could get by for less and give what remains to your heirs. But if you annuitize, you could give away that 25% to 40% extra cost of providing for longevity contingencies, either now or later, as we explain under Item 5 below.

Another problem with such homemade annuities is the lack of predictability. Phased withdrawal plans require adherence to a strict discipline over the remainder of your life.  They require you   to consume   for many   years   at   a   substantial y lower  rate  than  the  life  annuity  withdrawal  rate  in  order  to  maximize  the probability that you won’t run out of money too soon. What if you, in a moment of weakness, violate the discipline? Moreover, all of the projections about the probabilities that a particular phased withdrawal plan will work in practice are based on distributional assumptions. That is a statistician’s way of saying that the behavior of the investment in question is being correctly modeled.   Quite frankly, we really don’t know what the future distribution of returns will be over the next 30 to 50 years, and whether it will match our assumed distribution. While we will not discuss here the important technicalities and economic ramifications of the assumptions embedded  in  the  return  distributions  used  in  these  programs,  suffice  it to   say that many financial economists have serious concerns about them. Returning to our Russian roulette example, we may know how many chambers are in the pistol, but we don’t really know how many of them are empty.

  1. If I put all of my money in a life annuity, will there be anything left for my kids?

There are several levels upon which this valid question can be answered. First, assume that you put all of your money in life annuities (which we do not advocate). If you have enough money to give some to your   heirs,   yet   place   it   al    in   life annuities,  the  monthly  payments  will  likely  be  more  than  you  need  to maintain your lifestyle. Therefore, the excess could be saved and passed on to them. The longer you live, the more excess will be available for your heirs.

But if you die soon, there will be very little to pass along. This can be remedied by using some of the extra  monthly  annuity  income  to  purchase  renewable  term life  insurance,  or  whole  life  insurance,  which can generate a sizable sum to pass along at death. Alternatively, you could purchase a life annuity with a feature that continues making payments for up to twenty years, or that refunds to your heirs that portion of the premium which has not been received in income, if death occurs within a selected time interval.

Furthermore, if you do not annuitize a substantial portion of your retirement wealth, you pass the financial risk of outliving your resources along to your relatives and children, not to a broad pool.  In such cases, your heirs could receive a windfall if you die prematurely, but very little or nothing if you live longer. In essence, lack of annuitization puts the heirs’ economic incentives averse to your own (assuming that you wish to provide a comfortable living for yourself in your old age), whereas annuitization resolves the conflict.

If  you  determine  how  much  income  per  month  you  need  to  live  comfortably for  the  rest  of  your  life, and fund it, can you give away the rest?  Yes, if you annuitize the portion of your wealth that is needed, setting  aside  some  additional funds   to   cover   unforeseen   needs   (perhaps   through   insurance).   You   will continue  to  receive  a  comfortable  income  throughout  the  remainder  of  your lifetime.  The rest of your wealth you can give away today, if you like, or at the end of your life, if you prefer. The present value is the same, but the heirs may be able to make better use of it if they receive it earlier than later, to cover their children’s college expenses, help them get into a house, or other such needs. It is likely that  if the heirs were consulted, their preference would be nearly universal for receiving a certain bequest up front, along with a smaller residual claim, than to leave everything for upwards of 40 years and possibly receive nothing.

But suppose you instead invest in some combination of mutual funds the same amount that it would have taken to securely provide for your needs through annuitization.   In so doing, your heirs become residual claimants. That is, they receive only what is left over after your passing. Ironically,  the longer you live  (and thereby  the  more  you  consume  of  your  wealth),  the  less  there  will  be  left over  for  your  loved ones. And if you live a long life, you may need your children to care for your physical, emotional, and financial needs.  Thus,  the  longer  they  care for  you,  the  less  they  will  receive  for  their  efforts  (in  present value terms). Under annuitization, the insurers absorb all of the longevity risk. Without annuitization, the heirs absorb all of the risk rather than the insurers.

How much better would it be to provide your heirs with a substantial legacy up front, upon retirement or perhaps even earlier, and then, at the end of your life, they can be residual claimants for personal effects and any unused funds?

  1. If  I  purchase  an  irrevocable  life  annuity  at  retirement,  don’t  I  lose control  over  those funds?

Yes.  And thankfully, so do your kids!  One  of  the  most  difficult  situations  in which   older   people   find themselves   occurs   when   there   are   many   people trying  to  get  their  hands  on  your  hard-earned  money. Let’s face it. Some of us get rather feeble as we age, and our judgment sometimes lapses. We become vulnerable  to  impassioned  pleas  from  others  to  “ante  up”  our  savings  to them.   How many aged people have lost everything in such situations, sometimes even to well-intentioned recipients?   Moreover, it also greatly reduces the risk of us overspending.

There  is  another  reason  to  place  these  funds  beyond  our  direct  control.  A recent  study  has  shown that older people typically earn roughly 2% lower annual returns  on  their  stock  portfolios,  even  when  adjusted  for  risk,  than  investors younger than 60.8 Sometimes it is best to leave your funds in the hands of experienced     professionals,     especially     when     they     have     contractual requirements  to  provide  you  with  a well-defined stream of desired benefits, and where their contract is backed by   the assets and   the entire surplus   of   a financially  solid  company.  Remember,  the  greatest  economic  risk  we  face today is  that  we will  live  longer  than  our  income  stream. Sometimes  we pay a  very high  price  for  maintaining  what we think is control.

  1. Shouldn’t I wait to buy in case interest rates go up?

Some   people   delay   annuitizing   in   the   hopes   that   they   can   get   higher annuity  yields  if  interest  rates increase. Very briefly, here are the issues.

It is true that if interest rates increase, annuity yields might also increase. But there are some mitigating factors to consider if you’re thinking about delaying to annuitize. First, your accumulated assets need to   be   invested   in   something during  the  interim  while  awaiting  the  time  to  purchase  a  life  annuity.  If invested  in  traditional  vehicles,  such  as  fixed  income  and  equities,  the  value erosion that typically accompanies rising interest rates may offset part or all of the gain that one hopes to garner by delaying the annuitization decision. Second, if life expectancy improves beyond the rate of improvement assumed in current pricing, the prices of the annuities themselves will climb. We calculated that a 1% annual improvement in life expectancy is associated with roughly a 5% increase in the price of an annuity, or a 5% reduction in monthly payouts. This decline in monthly annuity payouts may be offset if the interest rate embedded in annuity pricing also increases, but it needs to increase sufficiently to offset any reduction caused by an unanticipated improvement in life expectancy as well as the probable reduction in accumulated as-set   values   occasioned   by   high   interest   rates during  the  delay  period.  Third, the awaited rising interest rates may not occur; indeed,  the  interest  rates  embedded  in  annuity  pricing  may  remain  stable  or decline, leaving the annuitant with lower monthly payments.  If interest rates and mortality rates decline together, these income reductions could be substantial.

Nonetheless, recent innovations in life annuity designs include one that allows the annuitant a second shot at higher interest rates. For example, one such product adjusts monthly annuity payments upward by roughly 18% if interest rates increase by 2% or more over the five years since purchase.

Conclusion

When individuals consider the list of positive attributes associated with life annuities, i.e., guaranteed payments  you  cannot  outlive,  low  cost,  access to   invested   capital,   and   reasonably   priced   features   such as inflation adjustment and legacy benefits, the argument for this income solution in retirement  is  compelling.  By  covering  at  least  basic  expenses  with  lifetime income annuities, retirees are able to focus on discretionary funds as a source for enjoyment. Locking in basic expenses also means that the retiree’s discretionary funds can remain invested in equities   for a   longer period of time, bringing   the benefits  of historically higher returns  that can stretch the useful life of those  funds even further. Income annuities may also be a vehicle that enables retirees to delay taking Social Security benefits until they are fully vested, bringing substantial y higher payments at that point. The key in all of this is to begin by covering all of the basic  living expenses with  lifetime income annuities.    Then,   to   provide   for additional   desirable   consumption levels, you will want to annuitize a goodly portion of the remainder of your assets, while making provisions   for   extra emergency  expenses  and,  if  desired,  a  bequest.  These last two items can be accomplished  through  combinations  of  insurance  and  savings.  When  this  is undertaken, you can enjoy your retirement without the burden of financial worries and focus on more productive uses of your time and attention!