Checked your retirement savings plan lately? January’s global stock market plunge is one of those moments that stoke fear among baby boomers that they might run out of money before they run out of years.
The fear is understandable: Older Americans are living longer. A man who reached his 65th birthday in 2015 has an average remaining life expectancy of 18.6 years, according to James Poterba, an economist at the Massachusetts Institute of Technology. A typical 65-year-old male also has a 20 percent chance of living an additional 25 years or more. For women in the same age group, average remaining life expectancy is 20.3 years; 1 in 5 will live to age 93.
Many economists have a favorite solution for those eager to get off the market’s roller-coaster ride while also hedging against a long life: a single-premium immediate annuity or lifetime annuity, preferably one with protection against inflation.
In exchange for a lump-sum investment, this type of annuity guarantees a steady income for the rest of your life. The payment stream depends on your age and the level of interest rates. But when you die, the value of the annuity typically goes to the insurer, not to your heirs.
Despite all the support for annuities among economists, there are good reasons for consumers to be wary.
While returns vary among insurers, according to the calculator at Immediateannuities.com, $100,000 invested in a single-premium immediate annuity would typically earn a 65-year-old man a $558 monthly income for life. A woman who is 65 would receive $535 monthly for the same investment. In essence, you’re buying yourself a pension.
Ross Rezac, 67, and her husband, Martin Skoro, 63, are intrigued. Rezac and Skoro are semiretired graphic designers in Minneapolis who are gradually winding down their firm, accepting business if it comes but no longer marketing their services. Their household portfolio is over $1 million.
“What attracts us to the annuity is the steady income,” Rezac said. “The advice we’ve had is that the stock market will implode over the next few years, and this is a way to solve that problem.”
Still, Rezac and Skoro are uncertain about taking the plunge. Do they really want to give up control over their savings in return for a monthly income? They worry that they don’t understand the trade-offs.
“Some people hate them and others think they’re great,” she says. “It’s confusing.”
Today, only about 10 percent of participants in defined-contribution retirement savings plans such as a 401(k) annuitize their savings when they retire. And the total amount is even more modest: In 2012, sales of individual fixed immediate annuities were just $7.7 billion, but households transferred $301 billion to individual retirement accounts from employer-sponsored plans.
Behavioral scholars have come up with reasons annuities aren’t highly regarded. These include “money illusion” (lump sum investment is so much larger than the monthly income stream) and “availability errors” (fear of dying right after signing the contract). Another reason is “smell of death” pessimism (buying an annuity means giving up hope of investing for gain).
But the reluctance to buy annuities is not irrational. For one thing, a broad-based stock index fund is far more likely to outperform the return on an annuity over most time frames, particularly when interest rates are extremely low, as they are now.
At the same time, there are other techniques people can use to reduce the risk of outliving their assets. These strategies include working longer, delaying filing for Social Security benefits until age 70 and cutting down on fixed household costs.
“I don’t have an annuity and don’t plan to buy an annuity,” said Meir Statman, a finance professor at Santa Clara University. “I am sufficiently responsible and have enough self-control that I can moderate my consumption around my circumstances.”
While marketed as supersafe, annuities do carry some risks. No investor should buy an annuity without making sure the insurance company has a top credit rating and a sound balance sheet.
Moreover, buyers should be wary of tying up all their savings in an annuity. Besides the risk of outliving your investments, “other risks may be more serious,” Arnold Kling, entrepreneur, economist and teacher, writes on his blog. “You could easily find yourself needing to take out a loan if your savings are tied up in an annuity and your spouse requires a home health aide.”
Felix Reichling of the Congressional Budget Office and Kent Smetters at the Wharton School of the University of Pennsylvania researched that insight. The model they developed suggests that annuitization is a risky strategy once health care shocks for the elderly are taken into account.
Fidelity estimates that on average a couple, both age 65 and who retired in 2015, can expect to spend an estimated $245,000 on health care during their retirement. Fidelity’s figure does not include nursing home and long-term care expenses.
“Most Americans in our model should not annuitize,” Smetters said. He does recommend considering annuities if you have at least $500,000 set aside first, half for medical expenses and half to tap when needed. His financial rule of thumb eliminates most boomers.
What are the alternatives? Social Security is an inflation-adjusted creditworthy annuity far superior to anything offered in the marketplace. Working longer, even earning a part-time income, makes it easier to delay filing for Social Security benefits until age 70. Waiting will produce real returns of 4, 5 or even 6 percent a year for those living to age 90 and more. “Social Security is an awesome annuity,” Smetters said.
Moreover, people heading into the traditional retirement years often underestimate how much they can reduce their financial risks by paying off their mortgage and reducing other fixed expenses.
“This is a better way to reduce risk,” said Ross Levin, a certified financial planner and co-founder of Accredited Investors Inc. in Edina, Minn. “Manage your expenses. Manage your cash flow. Pay attention to debt. Pay attention to taxes.”