Vanguard is not an insurance company, but that doesn’t mean we don’t appreciate the potential value that some see in having a guaranteed income in retirement.
In fact, you may have heard that Vanguard recently introduced Vanguard Annuity Access™, powered by the Income Solutions® platform. This is an online annuity marketplace where you can compare quotes on comparable fixed annuities from a set of leading insurers. The program is designed to facilitate easy, apples-to-apples comparisons among different annuity contracts, with the highest degree of fee transparency possible. This new service may be very helpful to those people seeking the kind of income guarantees an annuity can provide.
There’s a lot to be said about annuities. They’re the focus of a great deal of attention in D.C. these days. And the amount of confusion that exists among consumers, policymakers, and even “experts” surrounding annuities and “lifetime income” is staggering. We won’t try to clear all of it up here, but we do have some thoughts to share.
To start, it’s important to clarify that when policymakers and academic economists talk about annuities, they generally mean “immediate life annuities” or “income annuities.” These annuities are insurance contracts in which you give an insurer a lump sum up front in exchange for that company’s promise to make regular payments to you as long as you live (or to you and/or an “annuity partner,” typically a spouse, as long as one of you is alive).
After you make this deal, you don’t have the option to subsequently “cash out” the policy and get your money back. An annuity provides essentially the same form of benefit you get from Social Security, or a traditional pension plan, except a private insurance company is the guarantor.
This type of annuity appeals to economists and policymakers because it can ensure that retirees spend their assets “efficiently”—where efficiently means maximizing the amount that can be spent and consumed while alive, on a risk-adjusted basis. In other words, many experts see the goal of retirement planning as enabling people to spend as much as they can (and as evenly as they can over time) while living, and then “die broke.” In this framework, dying with “extra” unused resources is a significant inefficiency.
Annuities and pensions eliminate this inefficiency because they’re designed to have zero residual value at death. If you die earlier than you’re expected to, whatever remains of what you paid to the insurer can potentially be used to fund payments to others who end up living longer. In theory, that means annuitants can have higher average income over their realized lifetime (on a risk-adjusted basis) than they could if they each had to manage their own spending through time. If you do it yourself, you always have to hold back at least a little on your spending in case you end up living longer than you expect you might.
For many reasons, annuities are less attractive in practice than they are in theory. For example, it seems clear that many people don’t consider leaving unused assets behind to be a complete waste. For those who don’t think leaving “extra” assets behind is a problem, life annuities aren’t an efficient solution. So the desire to leave bequests (or maybe more accurately, the lack of concern about “accidentally” leaving a bequest) may be an important reason for the lack of demand for annuities.
Even if people only care about what they’re able to spend while alive, there are other issues. One is pricing. On average, it’s been found that people who voluntarily purchase life annuities tend to live longer than the rest of the population. Hence annuity payouts must be set lower than they could be if “annuitants” had lifespans that matched the overall population. This has the effect of making annuities less appealing (i.e., more expensive) for anyone in poor health or with simply average life expectancy.
In addition, annuities are not unconditionally guaranteed, as they generally are in theoretical models. Insurers can and do go out of business, though there is a state-by-state back-up system (subject to limits and caveats). There are also some significant tax concerns and other issues like risk-sharing within families (for even more info, see the Vanguard white paper Understanding Income Annuities).
Perhaps most important, annuities are irreversible. Things change. Disasters occur and opportunities arise. Planning for contingencies is one thing, but adopting a financial strategy that extinguishes (or at least impairs) the option to do anything else has real costs.
All of these drawbacks need to be considered alongside the big benefit of annuities: They provide lifetime income, guaranteed by an insurance provider.
So should you be thinking about buying an annuity in retirement? Of course, most retirees already have some annuity income via Social Security. So the question really is: Do you want more annuity income?
If you believe that Social Security and other pension income provide too little low-risk, lifetime income, then our view is that you should seriously consider some level of additional annuitization. On the other hand, if you feel like you have a sufficient spending floor from other low-risk sources, you might stick with a prudent withdrawal strategy from a portfolio of assets. You can always look at the issue again later—as long as you preserve a significant portion of your assets.
Our view is that ultimately, annuitization is about deciding what absolute minimum income you want to ensure in retirement. Unfortunately, no algorithm can tell you that answer, and it’s a decision you must make yourself. For most retirees, rock-bottom minimum needs may be quite modest. In Washington, policymakers worry a lot about low-income retirees with limited resources running out of money. Yet for this segment of the population, a relatively large portion of retirement income will come from Social Security. This group may therefore have the least desire for additional annuity income. Demand for annuities could be highest among the relatively affluent, where Social Security’s guaranteed income provides a much lower “safety net” relative to what someone might need (or simply be accustomed to).
If you think you need more guaranteed income, it’s perfectly sensible to buy it over time – something like dollar-cost averaging into annuities can make sense. And diversifying among providers is a good idea too.
Investors face large investment risks in retirement—witness 2008–2009—as well as longevity risk, the risk of living a lot longer than anticipated, and other risks. At the same time, while an unexpectedly long life or poor markets could mean very painful adjustments, it’s possible to view painful adjustments in some circumstances as less consequential than giving up control of large amounts of assets in all circumstances going forward. It’s very hard, then, to say that low usage of annuities necessarily is “irrational” or a “policy problem.”
For most retired and retiring investors, who will be receiving a significant amount of secure income from Social Security, it remains to be seen whether the appeal of additional guaranteed income will trump control and flexibility, even in today’s challenging market environment. We expect that flexible portfolio-based solutions and gradual withdrawal strategies will remain the dominant way in which retirees access their retirement assets for many years to come.
• Product guarantees are subject to the claims-paying ability of the issuing insurance company.
• Vanguard Annuity Access is provided by Vanguard Marketing Corporation and is offered in collaboration with Hueler Investment Services, Inc. through the Income Solutions platform. Income Solutions is a registered trademark of Hueler Investment Services, Inc. and used under license. United States Patent No. 7,653,560. Products may not be available in all states. Vanguard Annuity Access is provided by Vanguard Marketing Corporation.