A New Look at the Payoff from Annuity Investments

Despite their importance as a relatively safe way to sock away a stable income stream for the future, annuities have not yet caught fire among investors. The Life Insurance Marketing Research Association, in a 1999 study, found that only 1.56 million individual annuity policies, covering 2.35 million lives, were paying out benefits. Yet as a reliable source of income over a number of years, annuities could be a vital supplement to Social Security for many middle-income Americans.

A new study by Jeffrey R. Brown of Harvard, Olivia S. Mitchell of Wharton and James M. Poterba of MIT for Wharton’s Pension Research Council shows that middle-income investors approaching retirement age may be missing a good bet if they overlook annuities. The authors undertook new calculations of the money’s worth of nominal (i.e., not inflation-indexed) annuities and found values between 90 cents and one dollar for each premium dollar paid by the average annuitant. (“Money’s worth” expresses the present value of future benefits relative to their purchase price.)

While that kind of return may not seem much of a match to mutual funds and other investments, people don’t buy annuities to get wealthy. They buy them to protect their existing wealth, accumulated by years of hard work, against the possibility that they might exhaust those funds before they die. “Mutual funds do not protect against longevity risk, the risk of outliving your assets,” notes Mitchell. “If you buy an annuity, it makes sure that you don’t run out of money when you are in your 80’s or beyond.”

Commenting on the study, Mitchell says an important finding was the impact of longevity on the value of annuity payouts. “Mortality patterns differ between typical annuity buyers and people in the population at large,” she notes. (One reason for this is that people who don’t expect to live long don’t buy annuities.)

Due to their longevity, annuity buyers get more for their money than might be expected. The study found that money’s worth from annuities for a randomly selected person in the population equals 80% to 87% of the cost of buying these products. When the payout is calculated over the longer average lifetime of the typical annuity buyer, however, this value soars to around 95% to 97%. “The money’s worth of annuities has also risen in the U.S. over the last decade, making them a more attractive component of the retirement portfolio than in the past,” Mitchell says. “We also found that the money’s worth values for nominal annuities are remarkably similar across the developed world.”

An important innovation of the research was the way the authors applied interest rate yields to calculate future annuity payouts. They based their calculations not only on the relatively conservative yields projected for U.S. Treasury bonds but also for the return on investments in relatively risky corporate bonds. They found that yields for 30-year corporate bonds carrying Best’s BAA rating are typically between 90 and 140 basis points higher than for Treasuries of the same maturity.

The study team used those data to calculate the expected present discounted value (EPDV) of several hypothetical annuities. The EPDV is the amount that would be required now to buy an annuity payable in the future. For a 65-year-old man with an average annuitant’s life expectancy buying a $100,000 annuity, for instance, the study team’s findings suggest an EPDV of $97,000 with the Treasury yields, compared to $88,100 with the corporate yields.

The authors also turned their attention to a kind of annuity that has almost no market in the U.S.: the inflation-indexed annuity. “Inflation-indexed annuities provide protection not only against longevity risk but also inflation risk,” notes Mitchell. “There is no other asset that can protect against both risks.”

Perhaps U.S. investors don’t understand the substantial value of inflation protection, or it may be that because inflation-protected securities are still novel products, it will take time for them to attract a substantial following among the investing public, Mitchell adds.

The study team found that inflation protection adds more than 15% to the cost of a policy, compared to a nominal annuity – and this may be another reason why investors shy away from this kind of product. It may take a period of hyperinflation before consumers realize how swiftly ballooning costs of living could demolish their assets.

On the assumption that the stock market provides some protection against inflation, many investors turn to equity-linked annuities. These combine a fixed-income element with a variable element, consisting of a portfolio of stock market index options. The added income generated by common stocks make them willing to put up with the volatility of the annuity’s payouts. But does it provide inflation protection? Brown, Mitchell and Poterba show that the U.S. stock market has historically not provided a good inflation hedge over the short term. Even low rates of inflation can do great damage over 20 to 30 years to the elderly, Mitchell points out.

As Americans take on increasing responsibility for managing their retirement assets, economists see annuities as a way to convert their accumulated wealth into post-retirement income. The fact that the market for annuities remains small may reflect a complacent assumption that economic prosperity will endure indefinitely. Perhaps the recent stock-market wobble will shake that certainty. If that happens, annuities could emerge as major products in the financial marketplace.

Citing Knowledge@Wharton

Close


For Personal use:

Please use the following citations to quote for personal use:

MLA

"A New Look at the Payoff from Annuity Investments." Knowledge@Wharton. The Wharton School, University of Pennsylvania, [22 February, 2001]. Web. [02 August, 2014] <http://knowledge.wharton.upenn.edu/article/a-new-look-at-the-payoff-from-annuity-investments/>

APA

A New Look at the Payoff from Annuity Investments. Knowledge@Wharton (2001, February 22). Retrieved from http://knowledge.wharton.upenn.edu/article/a-new-look-at-the-payoff-from-annuity-investments/

Chicago

"A New Look at the Payoff from Annuity Investments" Knowledge@Wharton, [February 22, 2001].
Accessed [August 02, 2014]. [http://knowledge.wharton.upenn.edu/article/a-new-look-at-the-payoff-from-annuity-investments/]


For Educational/Business use:

Please contact us for repurposing articles, podcasts, or videos using our content licensing contact form.

 

Join The Discussion

No Comments So Far