The Retirement Conundrum

Notes from Jason Scott's FAJ article "The Longevity Annuity: An Annuity For Everyone?"

The retirement conundrum is how to "turn a pool of assets into a stream of retirement income."

Academics says annuities are the way to go. People don't like annuities and the advisory industry doesn't like annuities. Annuities are too complicated, too expensive, and force you to give up your assets.

The research indicates that a deferred annuity (as distinct from an immediate annuity) is optimal for retirees unwilling to fully annuitize. For a typical retiree, allocating 10-15% of wealth to a deferred annuity set to start late in retirement creates spending benefits comparable to an allocation to an immediate annuity of 60% or more.

It was four decades ago that economic theory concluded that individuals who wish to maximize guaranteed spending in retirement should convert all their available assets to an immediate annuity.

Deferred annuities are preferable to immediate annuities because of the well documented behavioral biases in decision making and maximize the insurance benefit per premium dollar.

The benefit of insurance depends upon the cost of insurance to the cost of replacement of the asset insured. You are looking to maximize the benefit per premium dollar (self insurance cost - insurance cost)/insurance cost).  To evaluate the potential insurance benefit, one simply considers the likelihood of a payout. If an insurance payout is unlikely, insurance is generally cheap relative to self insurance and insurance can provide substantial benefits. If an insurance payout is highly likely, insurance cannot be provided at must of a discount to self insurance.

Securing spending in the future with bonds (liability matching using zeros) is analogous to setting aside the full replacement cost of the car (or income desired). A zero coupon annuity offers spending in 20 years at nearly a 50% discount to self insurance in the bond market.

Implication: Get retirees or those close to retirement to take some portion of their accumulated assets and purchase a 10, 15, 20, 25 year deferred annuity. They can use the difference to live on (along with social security) until the deferred annuity kicks-in (while using the residual assets as well).

Immediate and deferred annuities just represent a bundle of zero coupon annuities. The difference is that immediate annuities add near term, low value annuity payments to the bundle, ie. they are much more expensive because they are much more likely to be claimed.

The optimal bundle of zero coupon annuities to purchase depends upon the amount of assets the retiree is willing to annuitize.

Uber wealthy don't really need to deal with this issue. Also the poor (those with few liquid assets) and the unhealthy are not good candidates for deferred annuities.