The academic literature is tremendously supportive of the power of longevity pooling (through the purchase of income annuities) to create better retirement outcomes for retirees.
For example, Wade Pfau’s 2012 study, An Efficient Frontier for Retirement Income, found that the efficient frontier generally consists of combinations of stocks and income annuities. Despite the academic support for including income annuities in portfolios and the fact that consumers highly value a guaranteed income stream for life, especially if it offers inflation protection, the adoption of income annuities by individuals is surprisingly lacking. Given the powerful benefits of annuitization, the anomaly has been referred to as the “annuity puzzle.”
The Benefits of Annuitization
For logical reasons, we insure against many different types of risks. We buy insurance to protect our homes and our lives. We also buy medical, dental, disability and umbrella insurance, and many people even buy travel insurance. We buy insurance to diversify risks that we find unacceptable to bear on our own because the costs of not being insured might be great. The same logic applies to the purchase of income annuities.
At its most basic level, the decision to purchase an income annuity (as opposed to a variable annuity, the purchase of which should generally be avoided) is a decision to insure against longevity risk–the risk that you outlive your financial assets. The “cost” of outliving your financial assets is extremely high, and the purchase of income annuities makes sense for those individuals who run that risk. If your client is such a person (and a Monte Carlo simulation can reveal if that is the case), you should strongly consider diversifying that risk. The mortality credits embedded in income annuities allow investors to increase expected returns relative to building a bond portfolio, trading off the liquidity benefits provided by publicly traded bonds.
Income annuities protect against longevity risk because payments are guaranteed to continue for as long as you live or, if a joint life with survivorship option is chosen, as long as you or your spouse lives. Further, because of mortality credits, the size of those payments will be higher than the level of withdrawals one could safely take from a portfolio of traditional assets of similar risk (e.g., a bond portfolio).
Mortality Credits Make it possible
How is an insurance company able to pay more than one could earn from a bond investment of similar risk? The answer is one of the most important, but perhaps least understood, features of income annuities—Those annuitants in the insurance pool who do not live to life expectancy are effectively subsidizing those who do. The longer answer is that annuities have built-in mortality credits.
The concept of a mortality credit can be illustrated by the following example. Suppose that on January 1st, 50 75-year-old males agree to contribute $100 each to a pool of investments earning 5%. They further agree to split the total pool equally among those who are still alive at the end of the year. Suppose also that we know for certain that five of the 50 people will pass away by the end of the year. That means that the total pool of $5,250 ($5,000 principal plus $250 interest) will be split among just 45 people. The result is that each person will receive $116.67, or a return on investment of 16.67%. If each person had invested independently of the pool instead, the total amount of money earned would have been $5, or a return on investment of 5%. The difference in returns between 16.67% and 5% is the mortality credit. Of course, fixed annuities are not one-year products; payments are made for life. It is the mortality credits that make income annuities a good option for some individuals.
Given the benefits of annuitization, why does the annuity puzzle exist? Among the explanations for the lack of adoption are:
- High fees;
- Lack of liquidity;
- Perception (and often reality) of high and non-transparent fees;
- Hard to buy. (Need to fill out paperwork and work with an agent.);
- High tax rates;
- Complexity. (One of the cardinal rules of investing is to not buy a product you don’t understand. Annuities are no exception.);
- Credit risk of the issuer;
- Bequest desire; and
- Irrevocability of the decision.
LifeX Tries to Solve the Puzzle
Stone Ridge Asset Management, with operational support from New York Life, is trying to solve the annuity puzzle by creating a product that is familiar to both financial advisors and their investors: a 1940 Act mutual fund offering longevity pooling.
Each LifeX fund intends to distribute monthly payouts through the end of the year in which the cohort turns 100. The distribution rate, defined as the annual distribution amount divided by net asset value (NAV), depends on the NAV at the time of purchase. A higher (lower) NAV results in lower (higher) payments.
Heirs inherit the net asset value if the investor dies before age 80. However, like most single-premium immediate annuities (SPIAs), nothing after age 80.
All LifeX funds offer daily purchases and sales of shares until the cohort turns age 80, at which point the funds intend to reorganize with and into a corresponding closed-end successor fund (the “Successor Funds”). The Successor Funds will offer no liquidity other than the monthly distributions living shareholders receive until December of the year the cohort turns age 100, at which point any remaining funds would be distributed to the investors still alive. The primary practical impact of the reorganization is simply that there will be no ability to invest or redeem shares beyond age 80, and shares will be canceled upon the death of the investor with no redemption value.
The availability of a reliable, inflation-protected income stream that is not impacted by stock market fluctuations reduces uncertainty, providing peace of mind and allowing investors to increase their current spending. The greater cash flow, along with its certainty, can also allow them to increase their allocation to riskier investments that provide higher expected returns and to illiquid investments that offer significant liquidity premiums and other risk premiums. Those can be helpful in addressing the bequest desire. In addition, assuming the LifeX purchaser has other assets, the added income provided by the mortality credits can result in more assets being available to heirs.
Another benefit is that if interest rates decrease, the NAV of LifeX funds will increase. Thus, if the investor redeems, they will benefit from the appreciation. Of course, the reverse is true if rates rise.
Income to Age 100
While LifeX does offer significant benefits relative to the typical income annuity, it is important to recognize that it is not an insurance product. Thus, it does not offer guaranteed income for life, as the last payments will be made in the calendar year the owner turns 100. While the odds of living beyond 100 are low, they should not be totally ignored. The significant benefits LifeX offers relative to typical annuities should be weighed against that risk. Those investors who place significant value on a guarantee beyond the age of 100 and who view that as more important than daily liquidity at NAV up to age 80 and more important than the greater tax efficiency of LifeX may be better off considering income annuities issued by highly rated insurance companies. Unfortunately, at least today, there are no income annuities that offer more than 3% inflation protection. Thus, the loss of that hedge should be weighed against the ability to insure income beyond 100.
When to Buy LifeX
Because LifeX provides the benefit of being able to sell the investment up until age 80, investors cannot earn any mortality credits until they reach that age. To clarify, prior to age 80 investors receive payouts reflecting anticipated mortality credits, but they essentially give back those “unearned” credits should they redeem, as their NAV will reflect the portion of the payments already made that relate to mortality credits. Thus, an alternative to buying LifeX at an earlier age is to build a ladder of TIPS (assuming you want the inflation protection) or nominal Treasuries (assuming you don’t want the inflation protection) out to age 100, and when you turn 79 cash them in and use the proceeds to buy LifeX. That would save the 1% per annum fee. But that strategy is not without risk, or transactions fees, as it creates the risk that interest rates could drop significantly to a point that LifeX would no longer be attractive. If that were the case, you would not have access to a longevity product with full inflation protection because the insurance industry offers only a maximum of 3%. Thus, buying LifeX before one reaches 80 can make sense in order to lock in what might be historically attractive yields.
Investor Takeaways
LifeX’s design as a mutual fund, not an insurance product, allows for significant costs to be removed from longevity insurance products while also offering a simpler experience for financial advisors and investors, along with liquidity until age 80 and improved tax efficiency. Those benefits address the annuity puzzle, helping investors increase their allocation to longevity insurance. Even so, some investors, especially those who place significant importance on the risk of living beyond 100, will still prefer to own an insurance policy with a highly-rated insurer providing a promise to pay.
While the mathematics suggest that delaying the purchase of LifeX until age 80 is the most financially efficient (with the exception of locking in current interest rates by purchasing before 80), for those willing and able to build and manage their own bond ladders, doing so might lead to the same psychological problem that has led to the annuity puzzle – too many investors ignoring the benefits of a reliable, inflation-protected income, with the mortality credits producing higher payouts than could otherwise be achieved. Purchasing before age 80 and receiving reliable payments for an extended period (over which some, or even much of, their principal will already have been paid back) could help overcome the emotional issues that lead to the annuity puzzle. For such investors, the psychological benefits could more than offset the 1% annual expense ratio of the fund. To address that concern, Stone Ridge has calculated that in the worst-case scenario, a 65-year-old male who purchases LifeX and dies right after age 80 would receive 88% of the principal back. That same male buyer at age 65 would have a 95% chance of having received 100% of their principal back prior to age 80.
One word of caution is that there is the risk that Stone Ridge could decide to shut down the funds if the product doesn’t generate sufficient investor interest with the result being that they cannot generate a profit. If that were to occur, the investor would still receive the NAV of the fund.
Larry Swedroe is the author of 18 books, the latest of which is “Enrich Your Future: The Keys to Successful Investing.”