Are plan sponsors and participants giving immediate annuities short shrift in designing income distribution strategies?
One Harvard PhD and veteran retirement wonk has published a working paper suggesting that may be the case.
Mark Warshawsky, a visiting scholar at George Mason University’s Mercatus Center, a think-tank dedicated to market-oriented policy solutions, has been testing the value proposition of immediate annuities on and off for three decades.
His latest research takes an apples-to-oranges comparison of the efficiencies of a annuitized retirement strategy versus the “Bengen” principal—the 4 percent drawdown rule on 401(k) investments that has arguably become the default approach to managing defined contribution assets.
“The immediate annuity market is not very active,” said Warshawsky, who served a central role at Treasury crafting the Pension Protection Act of 2006 and has been the director of Retirement Research at Towers Watson.
After all of his research, that still surprises Warshawsky, who expects the uncertainty facing this generation of retirees will force greater consideration of annuitized options.
“In the past, people were lucky. Stock markets went up, housing prices went up, government was providing more benefits through Medicare, and people had pensions. If you retired 10 or 20 years ago you likely found yourself in a pretty good situation,” he said.
“Going forward, none of that is going to be true. People need to be much more sharp and efficient in dealing with longevity risk,” added Warshawsky.
To be clear, his research shows that annuities are not always a viable option. Retirees in their 50s might not benefit from an annuitized strategy because of the contracts’ illiquidity; tie assets up in an insurance contract and they won’t benefit from the time younger retirees have to see them grow in the market.
But Warshawsky found that as people approached the more typical retirement ages of 62 to 70, annuities produced a higher average income three-fifths of the time compared to the 4 percent Bengen rule.
He generated projections of the income produced on a $100,000 immediate annuity, using historical yields on 10-year Treasury bonds and different lifetime simulations, to see how the payouts compared to the 4 percent drawdown strategy.
Non-annuitized 401(k) assets were held in a 50/50 stock-to-bond blend, and paid a low fee (20 basis points). Historical valuations of the Standard and Poor’s 500 stock index were applied, and 4 percent was drawn down from the assets annually, producing a dollar amount that was raised annually with the price of inflation.
While Warshawsky’s research may require a Harvard PhD to validate, he insists he’s deploying a simple comparison, and that while immediate annuities faired well in his models, they certainly are not the best option for every situation.
Retirees with more assets, and those with significant defined benefit pensions might not need annuities to guarantee they don’t outlive their assets. And those hoping to one day bequeath assets, as well as those who can predict a shorter life expectancy, will be uneasy with the annuity option—once assets are surrendered in premium to a contract, they’re not coming back.
Others knock annuities for their interest rate risk, or what Warshawsky prefers to call their “timing risk.”
His data certainly shows some fluctuation in what a $100,000 annuity pays out. In 2008, the average payment issued to a 65 year old was near $700 a month. In April of 2014 that average was below $550.
While current low interest rates are definitely something to take into consideration—Warshawsky favors a laddered approach to annuitizing portions of savings in this climate—he reminds that rising rates are bound to be equally volatile on stock holdings that remain in plans or invested lump sums.
And though he supports the annuitized option enough to put his money where his mouth is (Warshawsky has started a private advisory that uses annuities, in part, to address retirement income distribution), he stresses that they are one option that can be part of a solution to some investors, but certainly not all.
“The general advantage to keeping assets in a mutual fund is their liquidity,” he said. “That’s attractive to a lot of people. But at the same time, we need to consider how we are going to finance retirement.”
There is a natural tension between the two options, which Warshawsky says goes up the “food chain,” from advisors, to plan sponsors, to the financial institutions with an interest in one option over the other.
“There will have to be a balance of those tensions. What I am saying in this research is that there is a clear role for annuities in the mix,” he added.