As they approach retirement, baby boomers are increasingly concerned about how best to manage their portfolios during the decumulation phase of their lives.  One of the challenges for advisors and investors is understanding what role annuities should play, if any.

Advisors have stridently criticized many annuities for their high fees and complex, hard-to-understand structures.  I will not focus on the merits of those criticisms. Instead, I will show why one type of annuity – the immediate annuity – can play a valuable role in a decumulation strategy.

Among the many types of annuity contracts, I will analyze single-premium immediate annuities (SPIA’s) in which an investor pays a lump sum to an insurer, in return for a guarantee of a specific annual income for the balance of an investor’s life. 

One basis for comparison is to compare the income streams from alternative strategies to annuities.  In a recent article, for example, Investment News compared corporate bond yields and annuity payouts.  In the current environment, corporate bonds appear to be a far more attractive bet on the basis of yield alone.  We cannot, however, legitimately compare the higher yield on long-maturity corporate bonds to the payouts from annuities without also accounting for the risks associated with corporate bonds. 

Advantages and disadvantages of annuities

The advantage of an annuity contract is straightforward.  The annuity mitigates longevity risk — the risk that an investor will live sufficiently long in retirement to entirely deplete their assets.  This risk is not trivial.  A recent Wharton study found that a healthy 65-year-old man has a 50% chance of living beyond age 85 and a 25% chance of living beyond age 92.  A healthy 65-year-old female has a 50% chance of living beyond age 88 and a 25% chance of living beyond age 94.

The seller of the annuity pools contracts sold to a large number of investors.  An annuity holder who dies early provides the additional assets to offset the burden of providing income to an annuity holder who lives longer than expected.  The diversification of individuals’ longevity risk in annuities provides a unique hedge against longevity risk that cannot be directly achieved through any other asset class.  This is the unique value proposition that annuity sellers provide: They can diversify away longevity risk, while individual investors cannot.

The potential downsides to purchasing an immediate annuity are that (1) the decision is irreversible; (2) it offers no wealth transfer to heirs; (3) the seller of the annuity may default; and, (4) standard annuity contracts provide no protection against inflation.  These are all real risks. 

On the other hand, longevity risk is also a very real risk.  The default risk for an annuity contract is small and hard to quantify, but potentially catastrophic.   The Wharton study cited above suggests that the rational allocation to annuities drops substantially as credit risk is considered.  This makes sense, but there is enormous uncertainty in trying to estimate default risks of firms.

Annuities vs. alternatives

There are three standard approaches to providing income in retirement for those who do not have traditional, defined-benefit plans:

  1. Use portfolio yield as income
  2. Systematically withdraw of assets
  3. Annuitize

I explored income investing in a recent article.  The goal of the income investor is to draw only the income generated by the portfolio and leave the principle intact.  The income generated by a portfolio and its market value will vary over time, however, even if the income portfolio is invested in a risk-free asset.  In the second approach, the so-called Systematic Withdrawal Plan (SWP), the investor draws a specific amount from the portfolio that may include various forms of income generated by the portfolio and/or proceeds from selling assets. 

Income investing is a variant of the SWP, of course.  In both cases, the investor creates a portfolio intending for it to provide a stream of future income.  The traditional income investor, however, tries to generate this income without selling assets and has no longevity risk – he will never totally draw down his portfolio because he never sells assets. 

Traditional income portfolios are not without risk,of course  In the Investment News article cited above, the author suggests that an income investor can generate an effective 5.7% to 5.8% safe withdrawal rate with a portfolio of corporate bonds.  My recent article on income investing discussed the investment-grade bond ETF (LQD), which has expected annualized volatility of 15% and yield of 5.3%. Higher yields naturally come with higher risks.  I discussed the relationships between bond yield and risk in detail.   The yield from risky corporate bonds cannot be substituted for a safe withdrawal rate, as discussed later in this article.  In the recent Investment News article, the author was assuming that the yield on corporate bonds could be treated as essentially risk-free.