Wednesday, 7 March 2007

Lessons from an Expert on Annuities

Moshe Milevsky is one of leading experts, if not the leading expert, on retirement finances and annuities. A professor in Finance at York University, he has written a number of consumer advice books and many research articles. He also heads the non-profit, public-service Individual Finance and Insurance Decisions Centre.

I have just finished reading his paper on variable payout annuities, charmingly titled How to Avoid Completely Outliving Your Money, and would highly recommend this very readable paper to all those who like me are preparing to transition from the financial accumulation phase to the consumption phase, aka retirement.

Some of the bullet points of note in this paper:
  • the value of annuities stems from the dispersal of the financial assets of the deceased amongst the survivors (but don't worry, or make nasty plans to bump off other annuitants, your benefits don't go up or down if people die sooner than expected ;-)
  • the longer you wait to buy an annuity, the more you will get per month
  • people who purchase annuities live longer than the population average; no, buying an annuity doesn't cause you to live longer, it's just those who do purchase them are healthier and wealthier than average and these people do have a tendency to live longer (PS insurance companies know this and price it in)
  • fixed payout annuities are very vulnerable to inflation, just like bonds; even at 2% annual inflation, there would be a 1/3 loss in purchasing power after 20 years; at 4% inflation it's down by more than half; the following words, written in 2002, are still true today "in today’s close-to-zero inflation environment, surprises can only be in one direction"; of course, insurance companies do offer fully or partially inflation-indexed annuities.
  • annuity quotes vary considerably among financial institutions so it is important to shop around
  • the greater your estate creation of bequest motives, the lesser should be your interest in annuities
  • with variable payout annuities the optimal age to annuitize is much earlier - about ten years; Milevsky shows one scenario in which the optimum age to buy an annuity for a single woman is 80 years old for a fixed annuity but 70 years old for a variable annuity; for a single man the same fixed vs variable annuity optimum is 70 years old vs 60. Milevsky points out these ages would change for different individuals
  • variable payout annuities enable one to construct an underlying portfolio of stocks and bonds that funds part of the annuity payment; this better matches financial theory that states one should be diversified between these asset classes and not just dependent on fixed rate / bond-type investments as is the case for a fixed annuity.
  • variable payout annuities also allow one to shift the payout proportion to either earlier or later years in retirement e.g. this can suit those who anticipate they will be more active and want to spend more early in their retirement and to tail off later on ... in fact, don't the round-the-world tours tend to diminish once people hit their 80s?
  • the greater the emphasis on consumption versus bequest motives, the greater the role of payout annuities in the optimal retirement portfolio
The IFID website has many other research and popular press articles on annuities. More to relish reading!


Anonymous said...

Are you thinking of getting an annuity of some sort?

CanadianInvestor said...

I might well do that at some point.

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