The Bogleheads' Guide to Retirement Planning (18 page)

The premiums that you and everyone else who bought an annuity paid are pooled together and managed by the insurance company. The insurance company grows the pool by investing it, makes payments to everyone who has paid in, and pays themselves for management and administration. Thus, there are four different stakeholders in your decision.

1. You (and often a joint annuitant), because it is your premium being committed, and you who will receive payments

2. The insurance company, which takes full control of the premium, invests it, redistributes it to you and other annuitants, and is paid for doing so

3. Other people who have bought annuities at the same time, because, to a large extent, the extra payments that must be made to the longer-lived annuitants come from money the shorter-lived annuitants contributed and didn’t receive back

4. Your estate, because if you are a shorter-lived annuitant, your remaining premiums are used to fund payments to longer-lived annuitants instead of becoming part of your estate

The payouts from an annuity come from three sources:

This leads to several conclusions about annuities. First, they pit your interest against the interest of your heirs. Annuities are the ultimate die-broke strategy. They allow you to spend more per month and insure you against outliving your money, even if you live to be 105, but they leave nothing for the estate if you die soon after buying the annuity. (However, see the discussion of guaranteed periods and premium refunds later in this chapter.)

Second, the advantage of an annuity—that the fortunate people who enjoy a long retirement get more than they put in—is paid for by the unfortunate people who do not and who get back less than they paid in. From a consumption standpoint, annuities are viewed as valuable insurance because they guarantee a certain income, but from an investment standpoint, annuities are a risky asset because the payoff depends on an uncertain date of death and the health of the insurance company in the future. If you think about monthly income that you cannot outlive, annuities look great. But if you think about dollars paid in versus dollars paid out, annuities look uncertain.

Third, because the insurance is charging a hidden load, annuities are actuarially unfair; when adjusted for the time value of money, if you choose to regard it as a bet between you and the insurance company as to how long you are going to live, on average the insurance company is always going to win. This should not necessarily be an objection, any more than it is with any other kind of insurance.

Imagine two similar neighboring islands, Decima and Lachesis, where the inflation rate and the interest rate are 0 percent. Every year, on each island, 1,000 islanders reach their retirement age of 50, and need $20,000 a year in retirement. Where Decima and Lachesis differ is in their mortality statistics. In Decima, everyone lives exactly 100 years. (Whether this is a happy situation is a matter for philosophers, but it certainly simplifies retirement planning.) In Lachesis, the mortality statistics are just like ours.

How much money does it take to support the two populations in retirement?
Figure 7.1
takes its cue from Omar Khayyám’s metaphor of a Cup of Life filled with the Wine of Life.

The glass on the left in
Figure 7.1
represents Decima. The width of the glass represents the number of people surviving at age 50, 60, 70, and so forth. The glass is equally wide all the way down, and represents the same number of people—1,000—at age 50, 60, 70, and so forth.

Source:
Commissioner’s Standard Ordinary 2001 Mortality Table

The glass on the right in
Figure 7.1
represents Lachesis. The number of people surviving decreases with age, so the glass tapers. The diagram is based on the Commissioner’s Standard Ordinary 2001 Mortality Table for females; the linear width shown on the page has been made proportional to the survivorship curve, despite the three-dimensional appearance.

The total amount of money needed to fund retirement on each island is represented by the amount of liquid needed to fill the glass. In Decima, everyone knows that they will live 100 years, and filling the glass requires 50 years worth of income for 1,000 retirees, a total of $1 billion—$1 million per Deciman.

In Lachesis, some live to be 60, fewer to age 70, fewer to age 80, and so forth. The glass tapers. The average retiring Deciman will live another 50 years, but the average retiring Lachesian will live only 30. It takes only about 60 percent as much wine to fill the Lachesian glass, or $600 million total—$600,000 per Lachesian.

Here is where annuitization comes in. Each Lachesian can choose to go it alone or join a pool of annuitants. If they decide to annuitize, each of them can pay $600,000 to some agency—a private insurer, perhaps—who will have enough to fill the glass and fund every retiree for life.

What if a group of Lachesians does not want to give up the control of their money and prefers to manage each of their individual savings separately? Then they face the same dilemma a real-life retiree faces. Each of them will need more than $600,000. Only some of them will live past age 80, but none of them knows who it will be. Any one of them could live to 100, so every one of them needs to set aside $1 million, just as in Decima.

A Lachesian who has $1 million could well decide not to annuitize, because if she lives only to, say, age 80 and uses only $600,000, then the extra $400,000 will go to her children instead of staying in the wineglass to fund the payouts for other annuitants. But a Lachesian with $600,000 is faced with the prospect of holding back and using only $12,000 dollars a year instead of the $20,000 she needs, even though on the average her $600,000 savings should be enough. By annuitizing, she raises the amount she can safely spend by $8,000 per year. The annuity pays her 67 percent more than she could spend by relying on her savings. This is not interest, because the interest rate in Lachesis is 0 percent, and it is not an investment yield—but it is just as useful in paying the monthly bills as if it were.

There are some wonderful tools available online for understanding and exploring SPIA options. Time spent on these web pages is time well spent, regardless of whether or where you choose to buy an SPIA. Berkshire Hathaway’s BRK Direct offers one good choice. Vanguard annuity experts who can provide information and quotes are available at 800-462-2391.

Any quote system you use will ask for certain facts about your situation. There are several factors that will influence the amount you would receive monthly. This section highlights some of those factors.

Gender affects annuity premiums because women live longer, on average. For a 65-year-old man or woman, the same $1,000/month annuity costs $132,321 or $143,109, respectively, or more than 8 percent more for the woman. Couples usually opt for a joint annuity, which pays out as long as either member of the couple survives; in this case, the premium rises to $158,002.

Existing medical conditions that may measurably shorten your life expectancy would cause you to overpay for an annuity you bought based on normal life expectancy. You should seek out insurers that offer medical underwriting. This option offers a reduced premium in exchange for proof of reduced life expectancy. Medical underwriting generally covers serious conditions like cancer, heart disease, and multiple sclerosis. Of course, you need to provide proof of the medical condition to the insurer.

One Boglehead who applied for medical underwriting with AIG found the procedure to be straightforward. She received an impaired-risk letter offering a rated age one year older than her real age and received about a 2.5 percent reduction on a $100,000 premium.

An SPIA can be bought with after-tax dollars (unqualified) funds, or it can be bought with dollars that are in a qualified tax-advantaged retirement account, such as a 401(k), profit sharing plan, and traditional IRA. If you use money from a tax-advantaged retirement account, you would usually opt to buy what is called a qualified SPIA. Buying an SPIA with qualified money is like doing an IRA rollover. The premium money passes directly from the current custodian to the insurance company. You will not owe income tax on money withdrawn and transferred from the retirement account directly into an SPIA. Withdrawing money from a qualified plan and taking personal possession of it before you buy an SPIA could have serious tax consequences. Speak with your tax adviser.

A qualified SPIA distribution is considered to meet the required minimum distribution (RMD) for that portion of a qualified plan. However, distributions from nonqualified SPIAs are not part of your IRA RMD. Check with your tax adviser when confusion arises about what is taxable and what is not.

A single life annuity provides payments for the lifetime of a single individual. The annuity payments stop when the annuitant passes away. That works for a single person.

Most couples would probably opt for a joint annuity. A joint annuity names two annuitants and provides payments for as long as either of them is alive. Joint annuities commonly offer the option of reducing payments when only one of the annuitants is still living. Naturally, reducing payments reduces the premium. For example, one quotation for $1,000 per month for a 65-year-old couple shows that electing a two-thirds benefit to the survivor reduces the premium by 8.5 percent.

If your analysis shows one person can live more cheaply than two, and you want to lower your premium by buying no more than you and your joint annuitant need, then you might consider electing such an option. Figure 7.2 illustrates the benefit reduction for a two-thirds benefit election.

Or this option can mean that payments are reduced only when the survivor is the joint annuitant but not if the survivor is the annuity owner—a seemingly unfair situation. If you consider this option, be sure you understand what your insurer means by it. See Figure 7.3 for a visual reference.

If you were planning to buy separate annuities in your name and your spouse’s name, perhaps to maximize Guaranty Association protection, it might be worth observing that you can create your own custom reduced-survivor benefit by combining annuities. For example, a joint SPIA paying $400 per month with no reduction, plus a single-life annuity paying $300 per month to you, plus a single-life annuity paying $300 per month to your spouse, equals $1,000 per month with 70 percent benefit to either survivor.