Income Annuities for Retirement Financial Security

Wharton Study Suggests Lifetime Income Annuities Best Asset Class for Retirement Financial Security

Reprinted from Businesswire.com. August 08, 2007 09:49 Dueling Asset Classes: Wharton Study Demonstrates That Lifetime Income Annuities Are Best Asset Class for Financial Security in Retirement

NEW YORK--(BUSINESS WIRE)--As Americans grapple with the challenge of potentially outliving their retirement savings, a new study, co-sponsored by the Wharton Financial Institutions Center at the University of Pennsylvania and New York Life Insurance Company, identifies lifetime income annuities as the most cost-effective and least risky asset class for generating guaranteed retirement income for life.

The Wharton academic study revealed that:

•Income annuities can provide secure income for one’s entire lifetime for 25-40% less money than it would cost an individual to provide a similar level of secure lifetime income through traditional means, thanks to an insurer’s ability to spread risk across large numbers of people;

•Consumers are not annuitizing enough of their portfolios even though income annuities are low-cost, available from creditworthy insurers, and provide guaranteed payments for life. Equities, fixed income and other investment products like mutual funds carry the risk of outliving one’s nest egg;

•By covering at least basic living expenses with income annuities, consumers have much greater flexibility in other areas of a retirement plan, including the ability to take more investment risk with the remaining portfolio; and

•Recent innovations in income annuities, such as annual inflation adjustments, legacy benefits and access to capital in emergencies, have helped elevate the products to a desirable asset class in retirement.

These findings are outlined in a paper entitled “Investing Your Lump Sum at Retirement,” which is based on an academic study entitled “Rational Decumulation,” co-authored by Professor David F. Babbel of The Wharton School and Professor Craig B. Merrill of The Marriott School of Management at Brigham Young University. The study explores financial options for retirees and compares income annuities with other asset classes in retirement.

“Living too long is fast becoming the major financial risk of the 21st century,” said Professor Babbel. “Combined with the challenges facing Social Security and the decline of corporate pensions, this adds up to a ‘perfect storm’ for retirees who might outlive their retirement nest egg. Compounding our concern is that those who have chosen to annuitize their wealth through private annuity purchases are relatively few today. Our research shows that only lifetime income annuities can protect individuals in an efficient way from the risk of outliving their assets and that this simply cannot be duplicated by mutual funds, certificates of deposit, or any number of homegrown solutions. We believe we’ve shown that income annuities clearly should be more widely used, given that highly rated insurance companies are reliable and inexpensive sources of guaranteed income streams in retirement.”

“With long-standing sources of guaranteed retirement income under stress, lifetime income annuities can play a pivotal role in helping consumers manage risk and establish the foundation for a secure and fulfilling retirement,” said Paul Pasteris, senior vice president of New York Life. “Today’s income annuity offerings are also designed to address many of the traditional consumer concerns discussed in the Wharton research, including access to cash when needed, inflation protection, and the ability to leave a legacy for one’s heirs, all while providing welcome peace of mind in retirement.”

Professor Babbel said, “Finally, markups have come down from 6-10 percent to less than half that today. Combined with the modernization of income annuities in recent years, insurers have eliminated most, if not all, of the reasons why consumers have largely avoided these products in the past. With our academic findings now defining the enormous consumer benefits of income annuities, the arguments are compelling in favor of adding these products to retirement portfolios.”

A copy of Professor Babbel and Professor Merrill’s academic study, “Rational Decumulation,” can be downloaded from:
http://fic.wharton.upenn.edu/fic/papers/06/p0614.htm.

Their paper, “Investing Your Lump Sum at Retirement,” can be downloaded from www.guaranteesmatter.com.

David F. Babbel is Professor of Insurance and Risk Management and Professor of Finance at The Wharton School, University of Pennsylvania and is Senior Advisor and Vice President at CRA International. Prior to joining CRA as a vice president in the Finance Platform and head of the Insurance Economics Practice, Dr. Babbel was a senior financial economist in the Financial Sector Development Department of the World Bank, and a vice president in the Pension and Insurance Department and senior advisor to Goldman Sachs. With over one hundred articles and publications to his credit, along with a number of books and monographs, Dr. Babbel is an expert in the fields of finance, investments, risk management, insurance, pensions, and international business. His specialties within these fields are life insurance, annuities, asset/liability management, fixed income securities, and valuation. In addition, Dr. Babbel previously served on the faculty at the Haas School in the University of California at Berkeley. During his more than 25-year career as an educator, Dr. Babbel has taught courses in finance, investments, fixed income, insurance, and risk management at the undergraduate, graduate, doctoral, and executive levels.

Craig Merrill is Professor of Finance and Insurance with Brigham Young University, where he has been a member of the faculty for more than thirteen years. He is also a Fellow of the Wharton Financial Institutions Research Center. Dr. Merrill teaches finance theory, derivatives, and corporate risk management in BYU’s M.B.A. program and his research focuses primarily on fixed income securities and derivatives, asset-liability management, and applications of financial pricing to insurance liabilities – in particular, fixed and variable annuities.

New York Life Insurance Company, a Fortune 100 company founded in 1845, is the largest mutual life insurance company in the United States and one of the largest life insurers in the world. Headquartered in New York City, New York Life’s family of companies offers life insurance, retirement income and long-term care insurance. New York Life Investment Management LLC provides institutional asset management and retirement plan services. Other New York Life affiliates provide an array of securities products and services, as well as institutional and retail mutual funds. Please visit New York Life’s Web site at www.newyorklife.com and GuaranteesMatter, a site dedicated to retirement issues, challenges, and solutions, at: www.guaranteesmatter.com for more information.

Key Findings of the Wharton Study

Two economists affiliated with the Wharton Financial Institutions Center, Prof. David F. Babbel (Wharton) and Prof. Craig Merrill (BYU, Wharton) have conducted studies on the optimal level of annuitization under a wide array of financial circumstances. Their findings emerge at a time when the decline in the number of Americans covered by defined benefit pension plans has alarmed economists in light of the confluence of economic and demographic changes underway. Prof. Babbel and Prof. Merrill found that it is optimal to annuitize a large portion of one’s wealth at retirement – a larger portion than many financial advisors have previously suggested. Similar to the steady monthly retirement income traditionally provided by corporate pension plans and Social Security, income annuities provide individuals with a guaranteed stream of monthly income for life in exchange for a lump sum payment to an insurance company. The professors found that the optimal portion one should annuitize depends upon the total accumulated wealth at retirement, the profit margins embedded in annuity pricing, age, risk tolerance, and the returns in the bond and stock market alternatives. They also found that, contrary to conventional wisdom, annuitization of a substantial portion of one’s wealth actually assists a retiree in providing a bequest for his/her heirs, and that the lack of annuitization renders one’s heirs, in effect, residual claimants with financial interests opposed to those of the retirees. According to the professors, the flexibility of modern annuities renders obsolete many of the criticisms that have been raised in the past.

Key findings revealed in the study also include:

•Immediate annuities offer the advantage of risk-pooling – The Wharton study found that because insurers can share the risk of outliving one’s savings across a large group of policyholders, income annuities can offer financial security throughout retirement using 25 to 40 percent less money than would be required to provide an equivalent level of financial security through a retirement portfolio that does not incorporate income annuities – a benefit no other financial product can provide.

•No other asset class can address the risk of outliving one’s nest egg without requiring much more money – Current mortality tables show that an average healthy American male at age 65 today can expect to reach approximately age 85 – but that same individual also has a 50 percent chance of living beyond age 85 and 25 percent chance of living beyond age 92. As a result, people who plan to cover their economic needs to their “life expectancy” – in this case, age 85 – still face a 50 percent chance of failure. The Wharton study explains that only lifetime income annuities can mitigate the financial risk of living too long by relieving consumers of the need to set aside the far greater sums they would otherwise need to allocate to other asset classes to ensure they would not outlive their retirement savings.

•Equities, fixed income and other investment products are not substitutes for income annuities – Professor Babbel and Professor Merrill demonstrate that, unlike income annuities, other asset classes fail to address the risk of living too long. In addition, the study shows that consumers who place their retirement wealth in investment products like mutual funds are subjected to greater risk, typically higher expenses, and returns that are unlikely to keep pace with annuity returns, when investment risk is taken into account.

•Covering basic living expenses with income annuities can enable significantly greater flexibility in other areas of a retirement plan – According to the study, if basic expenses are covered by income annuity payments, individuals can keep their discretionary funds invested in equities for a longer period of time, providing the benefits of historically higher returns. This approach can also enable retirees to delay taking Social Security benefits until they are fully vested, providing substantially higher payments.

•Several insurers have added consumer-friendly innovations to the income annuity product platform, virtually eliminating the traditional reasons for not purchasing – According to the professors, features such as annual inflation adjustments, access to capital in emergencies, legacy benefits, interest rate protection, and the ability to increase or decrease payments at a future date make historical reasons for not purchasing income annuities no longer valid.

Note: I have long been an advocate of annuitizing annuities, suspecting many, but clearly not all, of the finding of the study.