Life After Full-time Work Blog

Love them or hate them, but understand them

I’ve written many blog posts on aspects of annuities. [For example, one on annuities, longevity risk and investment risk; another on the role of deferred annuities.] It occurs to me that there are psychological angles that are worth reviewing, some of which are financially relevant and others of which affect our thinking even if they’re not logical.

Let’s start with the definition. An insured lifetime income annuity  is a contract under which you pay a lump sum to an insurance company, and in exchange it guarantees to pay you a specific income for the rest of your life, no matter how long that may be.

Why would such a contract be attractive to you? Because you’re afraid you may live so long that you outlive your money.

So, if you can’t be sure, how is it that the insurance company can guarantee it? By pooling you with numerous others who have the same fear. Obviously your length of life is uncertain (and therefore a financial risk to you); but as far as the insurance company is concerned, it puts you into a financial pool with numerous others, and it is much more certain about the average length of life of the members of the pool: having some live longer than average is compensated for, in the aggregate, by others living for less than the average lifetime. So, for you as an individual, longevity may be a big risk; but for the insurance company the aggregate is reasonably predictable.

Just to be on the safe side, the insurance company adjusts its pricing by adding in two safety margins. One recognizes that, if you’re already in below average health, longevity isn’t a big fear for you and you won’t buy an annuity; so the projected longevity for the group of likely buyers is longer than average. The other recognizes that longevity is itself increasing, so there’s another margin built in to compensate for that. (More on this aspect later.)

There are other aspects that make an insured annuity attractive.

One is that it provides a predictable income, free from equity market volatility. But of course that’s also a disadvantage, because in exchange for avoiding volatility you accept an average amount of income that’s probably lower than if you invested in equities. It’s really a trade-off between hope and uncertainty, rather than a financial advantage or a disadvantage, but we tend to put our psychological preferences in play here.

Another is that you can structure the payouts to take a second life into account. For example, you can contract to receive level payments while either or both of you and your spouse are alive; or you can elect higher payments while you’re both alive, falling to (let’s say) two-thirds after the first death, to recognize that the survivor won’t have all the expenses that the couple encounters.

(Mind you, I’m assuming in all of this that the solvency of the life insurance company is not in question, or that the country in which the contract is purchased has safeguards that protect the annuity purchaser in the unlikely event of the insurance company’s default.)

Remember that I mentioned that the insurance company builds in margins? That means that you’re paying more than is probably strictly necessary to cover the pure longevity risk.  And there’s another factor that points further in the same direction: the insurance company incurs expenses in creating, selling, administering and holding financial reserves for its annuities, and those expenses are also built into the purchase price. So it’s inevitable that you’re paying more than the pure longevity risk requires.

How much more? And is it worthwhile for you to pay the extra amount, in order to be able to pool your personal longevity risk? Let’s take a look at both of those aspects.

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First, how much more are you paying? There’s a concept called “money’s worth,” which is simply the ratio of the value of the pure risk to the amount you pay. For example, suppose that ratio is 90%. That means that, for every $100 of your purchase price, $90 is the fair price to get you into the pool, and the additional $10 goes to the insurance company to pay for its expenses and profit margin.

So, what is the money’s worth, in practice? It’s awfully difficult to tell, obviously, because nobody knows what the actual longevity of any group will turn out to be.  I rely on academics to write papers about this, knowing they have no axe to grind. And two sets of results come to mind.

One is an October 2025 (so, very recent) update of a paper first published in 2021, relating to the US market. It estimates the money’s worth as 87% if your longevity aligns with the US population; if your longevity is greater, aligning with that of the typical annuity purchaser, your money’s worth is an astonishing 100%. (How so? Possibly because longevity improvements are fading; or, I’m guessing, because the insurance company is buying very slightly risky bonds and passing on some of the higher yield to the purchaser.) For deferred annuities purchased at age 65, with the payout not starting until age 75, the authors estimate the money’s worth at 73% and close to 100% , for the two estimates (population and annuitants) of the purchaser’s longevity.

The other calculation of money’s worth relates to the UK market and comes from a book that reviews many aspects of that market. The authors’ estimates vary between 85% and 100%. I remember a much earlier set of UK money’s worth estimates by the same authors, coming in at 77% and 88%. But I also remember a caveat: these relate to level lifetime annuity payments only. If you want your payments to increase every year to match inflation (so, to preserve the initial purchasing power), the money’s worth fell (this was in 2007) to between 70% and 80%. To say it another way, if you’re looking for inflation-indexed annuities, your money’s worth is (was) likely to be noticeably lower. No doubt this arises (arose) because the range and volume of inflation-indexed bonds offered by the government are much lower than that of nominal bonds, making the guaranteed payments more difficult to match.

Why would you want to preserve the purchasing power of your annuity payments? For the obvious reason that, as inflation puts prices up, it would be nice and convenient to have annuity payments made to you that match the average price increase. Indeed, one might ask: why would you accept nominally constant payments, which would obviously represent decreasing purchasing power if inflation continues? And there really is a rational answer to that question. It’s that, over time, our amounts spent on our lifestyles tend to decline as we age. Dr David Blanchett describes this as our “retirement spending smile,” in that our purchasing tends to decline roughly 1% a year, before increasing at the end if long-term care is involved, the overall shape looking like a smiling mouth. Another way to put it is that we tend to cope naturally with the first 1% a year of inflation.

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By now you’ve probably forgotten that I posed two questions. The first one (what is the money’s worth?) we’ve dealt with. The second was: is it worth paying the extra amount, as compared with the cost of self-insuring (rather than pooling) your personal longevity risk?

Well, the simplest way to look at this second question is to frame it slightly differently: how much would it cost you to self-insure your personal longevity risk?

That depends on how much certainty you want, as you self-insure. For example, if you want total certainty, you can calculate how much income you could withdraw (assuming investment in government-guaranteed bonds, meaning no investment risk) if you lived all the way to the end of the longevity table, which these days is age 120.

I did a quick calculation. Let’s consider a male aged 65, for example. On the day I did this calculation, US 10-year government bonds yielded roughly 4.1%. The cost of a (monthly-income) annuity that continues to age 120 (that is, 55 years) is then 22.16, so that every $100,000 of capital buys you an annual income of $4,513.

Compare that with a reputable insurance company’s annuity contract that guarantees you $7,180 a year for as long as you live. Your self-insured income is only 63% of that amount. You’re giving up 37% of your insured income by not pooling your longevity. When you look at that enormous cost of self-insuring, who cares if your money’s worth is in the 90%-100% range? In effect, your money’s worth is only 63% when you take into account the cost of self-insurance.

OK, agreed, that’s an extreme example. Suppose you don’t want 100% certainty, when self-insuring. Suppose you only wany 95% certainty. That would take your estimated age at death, not to 120, but to 96, according to Social Security’s 2022 longevity tables. In turn, that would take your annual income up to $5,641. That’s still only 79% of your insured income. And that 79% is still far below your insured income’s money’s worth.

What all this means is that, if you’re in reasonable health, your financial risk arising from the possibility of above-average longevity is much cheaper to insure via an insurance company than to self-insure.

That’s a reason to buy an insured lifetime income annuity. And to customize its payout terms to suit you and your spouse.

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I mentioned that we are often subject to behavioral idiosyncrasies. They complicate the subject.  What I mean is that people have emotional reactions to many aspects of the different approaches. Some of these reactions are valid emotions, even if they seem to push us into worse expected outcomes that purely rational thinking would lead us into.  Other reactions are just plain wrong. For example …

• Most people underestimate their longevity. They may only remember what life expectancy at birth was, when they were born; or perhaps they’ve updated that number to current life expectancy at birth. But that’s just plain wrong (at any rate, for those in at least average health) because the expected age at death increases as one ages, since aging makes one a member of a more elite group of survivors.
• Although an immediate lifetime income annuity has been shown to be the optimal approach for a retiree with no bequest motive, most people prefer to retain some flexibility to adapt to changing economic conditions and changing life circumstances. The desire for flexibility is a natural and reasonable emotional goal that isn’t taken into account in the standard “financial utility function” (which is a technical term used by nerds to tell you what to do). So it’s reasonable not to use one’s entire capital to purchase an annuity, in order to preserve flexibility.
• Less rationally, people often think of an annuity purchase purely as a gamble: “To buy lifetime protection, I’m taking a gamble, and I could lose all my money if I die early.” Not so. First, don’t buy an annuity unless you’re in better than average health: that alone shifts the odds into favoring you. Second, this may be the reason why many purchasers insist that their contract includes a guarantee, such as a refund of the balance of the purchase price if, at subsequent death, not all of the purchase price has been repaid as income; or perhaps some minimum period of payment, such as 10 years, if death occurs before that period expires. It’s true that such additional guarantees are more satisfying emotionally; but they don’t make financial sense (because they decrease the annual lifetime income you buy, so there’s a cost to your lifestyle) unless you also have a bequest motive, and want the possibility of leaving something from the purchased annuity to your heirs if you die before the average age that your health suggests is reasonable.
• Most people have a negative reaction to the word “annuity” but a much more positive one to the expression “guaranteed income for as long as you live.” This suggests that it isn’t just financial notions that the average person (for example, a new retiree in a “defined contribution” (or DC) pension plan) will need to think about, it’s also the ways in which those notions are expressed. So, for example, default options in a DC plan should refer to lifetime income rather than annuities.

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There’s a lot of meat there! Many ideas to process. You’re not alone if, by now, you think: let me set this aside for a while, and try to absorb it in more detail later.

That’s because, as I remember, there are three stages in the evolution of ideas. First there’s the leading-edge stage, in which there are a few pioneers, and lots of innovation and testing. Then some variants of those ideas survive and become mainstream, and there are many practitioners involved. Eventually the idea becomes a commodity: it’s accepted wisdom, and everybody uses a common form. I mention this because today pretty much all angles regarding guaranteed lifetime income payments as a form of decumulation are, I think, still in the first, or leading-edge, stage. It’ll be a long time before they’re commoditized.

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Takeaway

For people in reasonable or above average health, an insured guaranteed lifetime income can make a lot of sense. So can customized variations on that theme. People generally, however, have emotional reactions to purchasing such a contract from an insurance company, some of which are rational and some of which are not.

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