Immediate Annuities

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Barry Barnitz
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Immediate Annuities

Post by Barry Barnitz » Mon Mar 19, 2007 11:04 pm

(contributions welcome)

An immediate annuity is one method of turning a nest egg into a stream of income payments. Decisions involving immediate annuitization should be made in conjunction with a well thought out withdrawal strategy. An immediate annuitization is often a payout option on a deferred annuity. For a basic introduction to immediate annuities, please refer to Vanguard's Plain Talk Series:

Should You Consider an Income Annuity?

The following definitions can help explain the technical terminology associated with Annuities.

Definitions
Annuity
Annuity Unit
Assumed Interest Rate (AIR)
Exclusion Ratio
Fixed Annuity
Guaranteed Minimum Withdrawal Benefit (GMWB)
Inflation Protected Annuity (IPA)
Joint and Survivor Annuity
Life With Guaranteed Term
Mortality and Expense Risk Charge
Straight Life Annuity
Systematic Withdrawal Schedule
Variable Annuity

bob90245 has completed a four-part series of articles on Immediate Annuities:

1) Immediate Annuities in Retirement
2) Annuities: A Primer
3) Pros and Cons of Immediate Annuities
4) Immediate Annuities Links Page

Return to the Table of Contents
Last edited by Barry Barnitz on Tue Jan 01, 2008 6:05 am, edited 7 times in total.
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An Immediate Annuity Primer:

Post by Barry Barnitz » Mon Mar 19, 2007 11:05 pm

Papers

1. The (Mostly) Pros and (Few) Cons of Lifetime Payout Annuities byThomas G. Walsh, F.S.A., C.F.P.

This paper discusses lifetime payout annuities and why annuitiescould be an option of choice for financial advisors when helping retirees make retirement decisions. The discussion covers the mechanics of risk pooling and the dual sources of payouts, investment income and return of principal. Differences between pure lifetime annuities, period certain annuities, and lifetime with period certain options are explored, as well as comparisons between payout annuities and regular withdrawals from one's investment account. We also consider questions regarding timing of annuitization, partial annuitization and certain criticisms of annuities, as well as a strategy that combines guaranteed lifetime income with a guaranteed death benefit for heirs.


2. Annuities and Inflation by Thomas G. Walsh, F.S.A., C.F.P.

A guaranteed lifetime annuity can maximize a retiree's annual income and provide an income that cannot be outlived, as discussed in our first paper, "The (Mostly) Pros and (Few) Cons of Lifetime Payout Annuities." However, fixed-rate annuities do not protect a retiree's income from purchasing power losses because of inflation (e.g. as measured by changes in the CPI). The purpose of this paper is to describe types of annuities and other strategies that will offer the possibility of growing payments during retirement.


3. Annuities:Now, Later, Never? by Benjamin Goodman, Director, Actuarial Consulting Services TIAA-CREF and Michael Heller, Vice President, Actuarial Consulting Services TIAA-CREF, October 2006
With the growing prominence of defined contribution plans as primary retirement funding vehicles, there is a concern that participants should be making appropriate decisions in drawing income from their account balances. One major question relates to the role of life annuities as an effective means of receiving retirement income. This paper examines the financial efficacy of receiving income through a life annuity versus systematic withdrawals from a participant's account. As a basis for comparison, we contrast the receipt of life annuity income to equivalent withdrawals made from an investment account, assuming that both the life annuity income and the investment account earnings reflect the same investment return (net of expenses). This form of comparison is done for both a typical fixed annuity and for a variable life annuity. Based on hypothetical future investment earnings rates, these illustrations show that the individual who utilizes systematic withdrawal is projected to run out of funds some time before reaching his or her life expectancy. In other words, there is more than a 50% chance that the individual would run out of money!


4. Reducing Retirement Income Risks: The Role of Annuitization by John Ameriks and Paul Yakodoski

Annuitization of defined contribution plan balances effectively reduces a variety of retirement income risks faced by retirees. This article reviews the changing role that insurance, especially life annuities, plays in solving the retirement income problem and the theoretical arguments and empirical studies showing the importance of annuities. It then reviews reasons why annuities are not more widely purchased by retirees and how policy makers can encourage annuitization in order to ensure the long-term financial security of future generations.


5. Merging Asset Allocation and Longevity Insurance: An Optimal Perspective on Payout Annuities by Peng Chen and Moshe A. Milevsky Date: February 20, 2003

Traditionally, asset allocation is determined by constructing efficient portfolios for various risk levels based on modern portfolio theory (MPT). Then, based on the investor's risk tolerance, one of the efficient portfolios is chosen. MPT is widely accepted in the academic and finance industries as the primary tool for developing asset allocations. Its effectiveness is questionable, however, when dealing with asset allocations for individual investors in retirement, since longevity risk is not considered. The purpose of this article is to review the need for longevity insurance during retirement, and then establish a framework to study the total asset allocation decision in retirement, which includes both conventional asset classes and immediate payout annuity products.


6. Asset Allocation with Annuities for Retirement Income Management by Paul D. Kaplan Date: 2005

Retirement income management is choosing a combination of annuity, withdrawal, and investment strategies such that it is unlikely that the investor will run out of money before death while achieving the investor’s financial goals. In making these decisions, the investor must manage both market risk and longevity risk.
In this paper, we explore retirement income solutions in a simple setting to illustrate the trade-offs that retired investors face regarding how much income they can generate, how much short-term risk they are exposed to, how large an estate they can expect to leave, and how likely they are to not run out of assets before dying (the “success” probability). We assume that at the beginning of the retirement period, the investor chooses how much annual income to generate (in real dollars), how much to invest in single premium immediate annuities, and what asset mix to use to manage non-annuitized assets.

contributed by cyberbob

7. Asset Allocation within Variable Annuities: The Impact of Guarantees by Moshe Milevsky and Vladyslav Kyrychenko (June 28, 2007)
The latest generation of variable annuity (VA) contracts contain equity put options plus longevity insurance. Much of the marketing material for these products, claim that these new riders should induce investors to take-on more financial risk. In this paper we examine whether this is indeed the case. Using a unique database we document that policyholders are in fact adopting higher equity exposures when these riders are selected. We also examine the theoretical merits of this advice by deriving the optimal asset allocation in the presence of these guarantees. Our main conclusion is that more aggressive equity allocations can indeed be justified in many, although not all product structures.
Last edited by Barry Barnitz on Sun Jun 07, 2009 3:34 pm, edited 9 times in total.

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Immediate Annuitization: Advanced Academic Papers

Post by Barry Barnitz » Mon Mar 19, 2007 11:07 pm

Advanced Papers

1. Optimizing the Retirement Portfolio: Asset Allocation, Annuitization, and Risk Aversion by Horneff, Wolfram J., Mitchell, Olivia S., Maurer, Raimond and Dus, Ivica (July 2006)

Retirees must draw down their accumulated assets in an orderly fashion so as not to exhaust their funds too soon. We derive the optimal retirement portfolio from a menu that includes payout annuities as well as an investment allocation and a withdrawal strategy, assuming risk aversion, stochastic capital markets, and uncertain lifetimes. The authors consider the following withdrawal strategies:

* Fixed dollar withdrawals
* Fixed percentage withdrawals
* Percentage withdrawals to longest mortality table (1/T)
* The MRD withdrawal (1/E(T)
* Total immediate annuitization
* Partial annuitization


2. Optimal Asset Allocation and The Real Option to Delay Annuitization: It's Not Now-or-Never by Moshe A. Milevsky and Virginia R. Young Version: 13 April 2002


By using reasonable capital market and actuarial parameters, we estimate that the real option to defer annuitization is quite valuable until the mid-70s or mid-80s. Of course, the precise values depend on one's gender, risk aversion, and subjective health assessment. Finally, we show that low-cost variable immediate annuities, which are currently not widely available, greatly reduce the option value to wait and create substantial welfare gains. This might explain the large number of TIAA-CREF participants who rightfully choose to annuitize their DC pension plan, as a result of the availability of both fixed and variable payments in the payout stage.


3. Money in Motion: Dynamic Portfolio Choice in Retirement by Horneff, Wolfram J., Maurer, Raimond, Mitchell, Olivia S. and Stamos, Michael (February 2007)

Retirees confront the difficult problem of how to manage their money in retirement so as to not outlive their funds while continuing to invest in capital markets. We posit a dynamic utility maximizer who makes both asset location and allocation decisions when managing her retirement financial wealth and annuities, and we prove that she can benefit from both the equity premium and longevity insurance in her retirement portfolio. Even without bequests, she will not fully annuitize; rather, her optimal stock allocation amounts initially to more than half of her financial wealth and declines with age. Welfare gains from this strategy can amount to 40 percent of financial wealth (depending on risk parameters and other resources). In practice, it turns out that many retirees will do almost as well by purchasing a variable [immediate] annuity invested 60/40 in stocks/bonds.


4. Life-Cycle Asset Allocation with Annuity Markets: Is Longevity Insurance a Good Deal? by Wolfram J. Horneff, Raimond Maurer, Michael Z. Stamo (December 2006)
We derive the optimal portfolio choice over the life-cycle for households facing labor income, capital market, and mortality risk. In addition to stocks and bonds, households also have access to incomplete annuity markets offering a hedge against mortality risk. We show that a considerable fraction of wealth should be annuitized to skim the return enhancing mortality credit. The remaining liquid wealth (stocks and bonds) is used to hedge labor income risk during work life, to earn the equity premium, and to ensure estate for the heirs. Furthermore, we assess the importance of common explanations for limited participation in annuity markets.
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Post by DaleMaley » Thu Apr 05, 2007 8:39 pm

Allocation During Retirement: Adding Annuities to the Mix by William Reichenstein, AAII Journal, November, 2003

Annuitization can greatly decrease longevity risk, the risk that the individual will exhaust his resources before death, but it may also decrease the amount of wealth available to beneficiaries.
Annuitization reduces longevity risk because, by design, it naturally pays off more the longer the annuitant lives. In addition, due to the annuity’s pooling-of-risk structure, survivors can receive higher payouts from an annuity than from their own investments.


[edit: formatting plus a quotation from study's conclusion-Barry]
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Post by alec » Fri Apr 06, 2007 7:31 am

How about:

1. Making Retirement Income Last a Lifetime by John Ameriks, Robert Veres, Mark J. Warshawsky.

2. ANNUITIES: NOW, LATER, NEVER? from Benjamin Goodman and Michael Heller.

- Alec

[edit: formatting for consistency-Barry]

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Longevity Annuities:

Post by Barry Barnitz » Tue Jun 12, 2007 11:36 am

1. The Longevity Annuity: An Annuity for Everyone? by Scott, Jason S., Financial Engines Inc. (June 2007)
As of 2005, individuals had an estimated $7.4 trillion invested in IRAs and employer-sponsored retirement accounts. Given these investments, many retirees will face the difficult problem of turning a pool of assets into a stream of retirement income. Purchasing an immediate annuity is a common recommendation for retirees looking to maximize retirement spending. However, the vast majority of retirees are unwilling to annuitize all of their assets. This paper demonstrates that a new type of annuity, a longevity annuity, is optimal for retirees unwilling to fully annuitize. For a typical retiree, allocating 10%-15% of wealth to a longevity annuity creates spending benefits comparable to an immediate annuity allocation of 60% or more.


2. Real Longevity Insurance with a Deductible: Introduction to Advanced-Life Delayed Annuities by Moshe Milevsky, (2004)
There appears to be universal agreement amongst economists and actuaries about the substantial financial benefits from payout (or immediate) annuity contracts, yet the public and press yet to embrace this risk management instrument. Furthermore, a consensus has yet to emerge about the optimal age at which to annuitize, as well as the optimal design of the ideal payout annuity. Indeed, the global trend away from Defined Benefit (DB) and towards Defined Contribution (DC) pension plans in conjunction with exceptionally low levels of voluntary annuitization cry out for a new way – or revisiting old ways – of thinking about the provision of lifetime retirement income. This paper explores the financial risk and return properties of a concept product called an advanced- life delayed annuity (ALDA) which is a variant of a pure deferred annuity contract that is linked to, and adjusted for, consumer price inflation. Reduced to its essence, our product would be acquired at a young age – and small premiums would be paid over a long period of time -- but the ALDA would only begin paying an inflation-adjusted life-contingent income at the advanced age of 80, 85 or even 90. The product would contain zero cash value, no survival or estate benefits, and could not be commuted for cash at any age. In theory, these features combined with standard actuarial, interest and (possibly) lapsation discounting would reduce the ongoing premium for this insurance to mere cents on the dollar. ALDA is a close relative of a defined benefit pension, and intended for those who don’t have one.


3.) An Annuity People Might Actually Buy by Anthony Webb, Guan Gong, and Wei Sun
Immediate annuities provide insurance against outliving one’s wealth. Previous research has shown that this insurance ought to be valuable to risk-averse households facing an uncertain lifespan. But rates of voluntary annuitization remain extremely low. Many explanations have been offered for retired households’ reluctance to annuitize. One prominent explanation is that annuities suffer from a considerable degree of actuarial unfairness. That is, for the average household, the expected value of the income, discounted by a rate of interest and annual survival probabilities, is considerably less than the premium paid. But it seems likely that households are also influenced by a reluctance to give up access to their life savings. In the past, households’ reluctance to annuitize was not a matter of great policy concern because most households held substantial proportions of their wealth in pre-annuitized form through Social Security and defined benefit pensions. However, the displacement of defined benefit plans by 401(k)s and projected reductions in Social Security replacement rates will increase the importance of a well-functioning and attractive annuity market. This brief evaluates a proposal for an innovative annuity product — the Advanced Life Deferred Annuity (ALDA). The ALDA is an annuity that would be purchased at retirement, or even earlier, but the associated payments would not start until some advanced age, (say) 75, 85, or 90. The long deferral period would result in a very inexpensive product. The authors estimate that a household planning to smooth consumption through its retirement would need to allocate only 15 percent of its age 60 wealth to an ALDA with payments commencing at age 85. The ALDA would thus allow people to preserve liquidity, overcoming one potentially important barrier to increased levels of voluntary annuitization.
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Post by alec » Sun Jul 29, 2007 4:44 pm

Rational Decumulation by Babbel, David F. and Merrill, Craig B., (July 2006). Wharton Financial Institutions Center Working Paper No. 06-14


We focus on the decumulation decision that faces an individual upon entering retirement, and seek a rational set of choices for an individual who receives a lump-sum settlement from retirement savings programs, together with accumulated private savings and Social Security credits. In the spirit of Merton (1969, 1971) and Richard (1975), we develop a continuous-time model to study the asset allocation choices, where life annuities are included along with fixed income and equity as the asset classes, and the inflation-protected life annuity is the riskless asset in an intertemporal context with an uncertain lifetime.

Unlike previous continuous-time models of annuities, wherein the existence of “actuarial notes” or “instantaneous term annuities” is posited and individual behavior relative to these hypothetical annuities is examined, our model accommodates more realistically the principal features and structure of actual annuities that are available – i.e., we consider irrevocable life annuities. Individual behavior differs markedly from earlier studies under a variety of economic conditions. In particular, high levels of annuitization are shown to be rational under a wide range of risk aversion levels, even when stock market returns and annuity price loadings are assumed to be much greater than is generally the case.

Ours is also the first study to model individual behavior under the possibility of default by the insurer issuing annuities. We find that even a little default risk can have a very large impact on annuity purchase decisions. We further find that state insolvency guaranty programs can have a big impact upon the levels of rational life annuity purchases –
particularly annuities of large size. This occurs even if the guaranty limits are relatively low. Higher guaranty limits have a much smaller incremental impact on annuity purchases. Insurers with lower credit ratings may benefit relatively more from such programs.


and

The TIAA Graded Payment Method and the CPI

For State Guarantee Funds providing protection from insurer default, see:

State Guarantee Funds
NOLHGA:What Happens When An Insurance Company Fails

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- Alec

[edit: added links concerning state guarantee funds-Barry]

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