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By Ruth Saldanha |

Annuities tips and planning for lifetime income

Interest rates, mortality credits, and asset allocation around annuities


Ruth Saldanha: We recently talked about annuity products that provide a fixed monthly income for life starting from a predetermined date in retirement, very similar to a pension. Today we delve deeper into annuities with Morningstar Head of Retirement Research, David Blanchett.

David, thank you very much for joining us.

David Blanchett: Thanks for having me.

Saldanha: First the basics. Annuities are a polarizing product. Some people love them; some people hate them. Do you think annuities are a good tool to generate income in retirement? And what kind of investor should consider this product?

Blanchett: Yeah, I think that there's definitely mixed feelings about annuities on both ends of the spectrum. I think that first, it's important to find terms. An annuity for me is a vehicle that creates income for life. There's all types of flavors. But when I use the word annuity, I'm focused on guaranteed income for a retiree. And then, under that lens the answer is, do they help retirees? It still depends. I think that individuals that really value income certainty that would invest conservatively without the annuity can really benefit from the annuities. So, high-level, I agree that there's definitely some disagreement about their value. But individuals that really want the benefit of income for life should definitely consider them.

Saldanha: Interest rates are expected to stay low in the immediate term and maybe rise later this year or early next year. Does it make sense to delay purchasing an annuity until interest rates rise?

Blanchett: I mean, it might – you know, I think it's really hard to predict interest rates into the future. I think that the longer you delay the purchase, the less you benefit from this thing called mortality credits. And so, there is something to be said for dollar cost averaging. Think of annuities as a long-term bond. And so, if interest rates do rise, they effectively become less expensive; I can buy more annuity at a cheaper price. And so, if I am someone who is worried about regret, about if I buy it today, what happens if interest rates do go up, then maybe buy a little bit today and buy some more tomorrow. I think that waiting just with the expectation that rates will rise is possible, but I think that if you want the guarantee, maybe ease into it right now versus waiting.

Saldanha: You mentioned mortality credits. Could you explain that please?

Blanchett: Sure. So, mortality credits are this kind of complex concept where when you buy an annuity you are pooling your risk, okay? So, there's 10 people get together, and they all agree that whoever is alive will receive a payment from this 10-person group for as long as they are alive. The benefit of that for those is if you are still alive – so, let's say, 30 years from now in that original group of 10 people only 5 folks are still alive, the payment that they receive is higher than if they had individually funded the contract because they are getting the advantage of those folks that have passed away. So, mortality credits is a way that you earn a higher effective return with an annuity if you survive longer.

Saldanha: You studied a few scenarios for optimal asset allocation with an annuitized income. Could you run us through the key findings?

Blanchett: Sure. So, an annuity is a type of asset and one problem I think with a lot of financial plans is that we often ignore guaranteed income on the balance sheet. So, we'll include the value of qualified accounts and nonqualified accounts. An annuity has a value. So, you can estimate the net present value of the cash flows. So, let's just use a simple rule of thumb. We'll multiply the pension benefit times 20, okay? So, if you receive a benefit that's $50,000 a year, that's increased every year for inflation. Let's just say that it's worth $1 million. That $1 million asset is effectively a bond. It pays you income for life that's guaranteed as long as you are alive. And the key asset allocation implications of annuities are viewing them as this bond-like asset and then possibly increasing the risk for the other parts of your portfolio.

So, high level, one of the key benefits of investing is diversification. And so, if I have a lot of bond-like assets on my balance sheet via annuities or pensions, I should take on more risk in my financial assets. So, the key with annuities then is to think about them and their risk holistically. So, if the annuity is fixed income – if a pension benefit is fixed income, how does it affect the rest of my portfolio. Usually, it means to be more aggressive. So, again, the key is thinking about the risks of all of your assets, not just your financial assets.

Saldanha: Thank you, David.

Blanchett: Sure.

Saldanha: For Morningstar, I'm Ruth Saldanha.

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