The Bogleheads' Guide to Retirement Planning (20 page)

Source:
Moshe Milevsky,
If Not Now,
When?
www.ifid.ca

In theory, the earlier you annuitize, the more benefit you should get from mortality credits. Before about age 60, the benefit is small, but there is a benefit nevertheless. So in a world where you could be totally confident in your decision to commit funds to an annuity, where the price of an annuity never fluctuated, and where there was no risk of insurer default, the earlier you annuitized, the better.

None of these things is true, so these risk factors weigh against annuitization by younger people. It is a balancing act made difficult by the fact that these risk factors are hard to evaluate. Personal preference—one’s degree of risk tolerance or risk aversion—weighs in the balance, and so do financial circumstances, specifically the need for secure income and the ability to meet it solely from one’s portfolio.

Several experts believe that age 65 is the youngest someone should be before using an immediate annuity, while waiting until the age of 90 is obviously too late. The experts are hesitant to advocate a single optimal age at which an investor should convert his or her savings account into an irreversible income annuity, given the many trade-offs involved in this decision and numerous sources of uncertainty.

Many experts suggest that immediate payout annuities should generally be purchased after retirement in staggered purchases because annuities are irreversible purchases that partially lock in investors’ asset allocations and reduce bequests.

Other things being equal, annuity payouts depend on the prevailing interest rate—roughly following the interest rate on the 10-year Treasury bond, as illustrated in
Figure 7.5
. Mortality credits are the amount by which the payout of an annuity exceeds the prevailing interest rate. Staged purchases help to dollar cost average across varying interest rates.

Because investment income forms only part of the annuity payout, a decline in a bond interest rate does not decrease annuity payouts proportionately. In fact, a calculation based on a life table indicates that an annuity could pay a 75-year-old man about 8 percent of the premium per year even if the insurance company earned no interest at all on its investment.

A simple answer to the question of how much you should annuitize is enough to provide for 100 percent of your minimum acceptable level of retirement income from all annuitized income sources, including Social Security and pensions. That immediately raises the question, What is 100 percent of your minimum acceptable level of retirement income? It is different at different stages of life. People in their 60s tend to spend more money than people in their 80s. So the correct answer may be that it depends when you annuitize. MetLife offers some help with a simplified online guide at
www.metlife.com
. Search for “Income Annuities Guide.”

Source:
U.S. Federal Reserve Bank

The economic models invariably demonstrate that the risk of not being able to cover basic living expenses far exceeds the benefit from the potential upside of taking on additional equity exposure. In calculating how much to annuitize privately, subtract the minimum from what is expected to be needed each month from the amount you will be getting from Social Security and any pension benefits you may have accrued. Then annuitize a sufficient amount of your assets to provide for the remainder of monthly income you will need to reach that threshold level.

There is a strong case to be made for annuitizing your absolute minimum living expenses. These are steady expenses that you must meet during all phases of retirement, whether you are newly retired or well on in your years. The SPIA represents an irrevocable commitment of funds, and a loss of control over them, so use an SPIA sparingly to fill the income gap between your other annuitized income streams and your expected lifelong minimum monthly expenses.

Donald Rumsfeld memorably commented: “There are known unknowns. That is to say, there are things that we now know we do not know. But there are also unknown unknowns. There are things we do not know we do not know.” The big unknown is whether you will outlive your annuity insurance company. If they go belly-up, you may be out some income. There are other unknowns that weigh against SPIAs. One is the possibility of buyer’s remorse. Rising interest rates after you buy mean better deals on SPIAs available in the future. Opportunity cost is a factor. Once money is put into an SPIA, it not available to use on anything else such as a vacation, a second home, education for the grandchildren, a business opportunity, or an emergency.

This section focuses on an important unknown, the risk of your insurer becoming insolvent. Purchasing an SPIA puts a sum of money into the hands of an insurance company irrevocably. You become partners forever. You cannot get your money back in a lump sum, and there is no cash value to borrow against. An SPIA owner relies on the long-term strength of the insurer, much like a pensioner relies on the financial strength of a former employer to continue making pension payments.

How big is the risk? Few annuitants have taken a loss on fixed annuities, but it has happened. Two relatively large insurance companies ended up paying only 70 cents on the dollar after they got into trouble as a result of bad investments. Mutual Benefit Life, which failed in the early 1990s, left hundreds of thousands of annuity holders with only limited access to their money for some eight years. The web site of the National Organization of Life and Health Insurance Guaranty Associations (NOLHGA) indicates that between 1991 and 2007, eight insurance companies have simply gone out of business, and there were 55 others for which guaranty association intervention was required.

In 2008, many unknown unknowns have made headlines. The safety of annuities has been thrown into the spotlight by the problems of American International Group, Inc. (AIG). Although it is not yet clear how the problems of the holding company affect the safety of its insurance subsidiaries, it has certainly reminded everyone that the safety of even the largest insurers cannot be taken for granted.

Annuities are backed by the state guaranty associations to a point and by the strength of the insurer. In every state, annuities are protected up to a dollar limit—often $100,000—by the state guaranty association. Insurance companies are regulated by states, not by the federal government, so the law is different in every state. Following some large insurance company failures during the 1980s, the insurance industry formed NOLHGA. The organization worked to create guaranty associations in every state and to make the law more uniform across states. You can and should look up the specific details for your own state, via the NOLHGA web site at
www.nolhga.com
.

Unfortunately, NOLHGA protection is almost a secret because most states prohibit insurance companies from explaining it to you. Banks have FDIC placards, brokerage statements mention SIPC insurance, but insurance brochures never mention the guaranty association. The insurance industry would like you to obtain your information about the program directly from the guaranty association—even though you are not told the guaranty association exists!

Insurers, particularly the stronger companies, have an interest in seeing this protection downplayed because of moral hazard, the danger that consumers could gravitate toward better deals from weaker companies. It is similar to shaky banks offering exceedingly high FDIC-insured certificate of deposit rates.

Here are a few points about the NOLHGA safety net worth noting:

The aggregate cap deserves special attention because it applies to several different kinds of insurance. A consumer with modest amounts of whole life insurance and long-term care insurance and a life annuity could very easily exceed the limits.

Protection on each individual kind of insurance, such as annuities, is usually per owner per member company. In a state with $100,000 annuity protection, if a complete list of the life, health, and annuity policies you own is two annuities, each valued at $90,000, with two different companies, you are fully protected.

The situation with respect to the aggregate cap is less clear. In New York, where the aggregate limit is $500,000, if an insured had three separate individual life insurance policies, each with a death benefit or cash value of $500,000 or more, with three different insurance companies, is the protection provided by the Guaranty Corporation to the individual $500,000 per company (in this case $1.5 million) or $500,000 in the aggregate, regardless of the number of companies or contracts?

A 2008 document issued by the Office of General Counsel of the New York State Insurance Department posed that question and answered: “Under the hypothetical presented, the protection afforded by the Guaranty Corporation would be $500,000 under each contract, for an aggregate coverage, should all three life insurers become insolvent, of $1,500,000.” (Source:
www.ins.state.ny.us
.)

Each state has different regulations and insurance limits, and there are often multiple agencies involved when corporations fail. Consult legal experts if you have questions about your particular state.

Five agencies that rate insurers are A. M. Best, Fitch, Moody’s, Standard & Poor’s and Weiss. Each agency ranks the financial strength of insurance companies using a proprietary scale, outlined in
Table 7.4
. There’s no way to compare ratings between different agencies. The rating methodologies are too diverse. For example, it is difficult to compare A+ from Best to an Aa2 from Moody’s. Thus, it is best to look at all the ratings and form a composite view.

Major ratings companies assign not only a letter grade but an outlook. A. M. Best uses positive, negative, and stable, and other modifiers or comments as well. A. M. Best uses
u
meaning “under review,” a warning that the rating may change.

These ratings are only a screening tool, not a guarantee. Walter Updegrave,
Money
magazine senior editor wrote: “These ratings are hardly foolproof. Rating agencies can get it wrong. And rapidly deteriorating markets can make what was a sound company weeks ago vulnerable today.” During 2004, AIG Life Insurance held S&P’s highest rating, AAA.