Morningstar Magazine - June/July 2018 - 14

Dispatches

regulations be simplified into a single, national
code. These recommendations, of course,
are unsullied by expertise. I did not commission
a market-research study on the subject.
That said, I think those proposals are on track.
In particular, annuity providers need to address the
deep distrust that they have instilled among the
most informed buyers. A business school professor
emails: "The two words that always come
to my mind when I think of annuities are 'rip off.'
I don't think that providers will ever publicize
an expense ratio because their jig will be up."
As word-of-mouth advertising goes, it is hard to
do much worse than that.
But what about annuities' investment merits?
In this endeavor, I can claim some genuine
competence-although the insights are not
directly mine, but rather purloined from
Morningstar's retirement-methodology team.
Ground Rules

We'll start by setting aside deferred variable
annuities-normally called simply "variable
annuities," but I want to distinguish them from
"immediate variable annuities." Morningstar's Paul
Kaplan recalls in an email a deferred variable
annuity conference he attended. "The opening
speaker was former N.Y. governor Mario Cuomo.
He said that after hearing what a deferred
variable annuity is, he won't buy one." While Paul
doesn't take investment advice from politicians,
he appreciates the governor's view. Deferred
variable annuities are neither fish nor fowl-not
exactly an investment fund, also not quite an
annuity. They often come with high expenses and
a bevy of complex features. So, no thanks.
There may be a good case to make for a low-cost,
relatively simple deferred variable annuity.
However, that is not the subject of this column.
Instead, the topic will be the uses of single
premium immediate annuities, or SPIAs,
which begin their payouts immediately after
purchase, and advanced life annuities,
which start their payments at some specified

future date. The differences in distribution rates
between those two versions can be dramatic.
Morningstar's David Blanchett tracked down the
best current available rates on lifetime annuities
for a single 65-year-old male. The immediate
annuity pays 6.25% per year. With an advanced life
annuity that starts payments in 10 years at age 75,
the annual payout balloons to 13.75%.
I use the term "payout" rather than "yield" or
"income" because, effectively, these single
premium annuities include return of capital in their
distributions. Which means that, yes, my
proposed label of "guaranteed income" isn't
strictly accurate. Perhaps "guaranteed payments"
is a better suggestion.
The Group's Advantage
The main benefit of an SPIA is straightforward.
As financial planner Michael Kitces explains, SPIAs

turn an uncertainty into a near-certainty.
Forecasting the life expectancy of a single retiree,
or even a married couple, is a highly uncertain task.
The date may arrive tomorrow or in 35 years.
Mapping out the distribution of life expectancies
for a large number of people, however, can be
done with high reliability.4
Because groups can be modeled with much more
certainty than individuals, they can be insured
more efficiently. This means that the person who
buys an SPIA can achieve a higher lifetime payout
rate than he or she can by purchasing government
securities-as with, for example, a bond ladder.
Of course, this benefit only remains a benefit if it is
priced appropriately. It is certainly possible for an
SPIA to carry such high costs that the prospective
buyer would be best off forgoing the advantage of
pooling with others, because the expenses of
doing so outweigh the prospective gains. Happily,
that is not currently the case with SPIA pricing;
when Blanchett surveyed today's annuity quotes
and compared their payouts against what
investors could achieve by buying Treasuries, he
found that the leading SPIAs do indeed offer better
payouts than would a self-insured portfolio.

(The reason for the SPIA's higher payout owes
to something called "mortality credits"-a topic
that I will bypass for this column. For those
interested, it is well covered by the Kitces article
referenced in the footnote.)
The Catch

The drawback of SPIAs is well known, major,
and oft-lamented: The money disappears upon the
purchaser's death. This makes SPIAs ill-suited
for those who wish to leave substantial legacies.
(Some annuity providers attempt to assuage such
fears by bundling death benefits into their
offerings, but the costs of such benefits often cut
so deeply into the annuity's payout that the
product is no longer attractive.) Most retirees,
however, do not have that happy problem.
Most SPIAs have fixed payments; others have
variable payments; and a third, less-common
flavor adjusts the payouts for inflation.
Morningstar's researchers have no preference
among the first two varieties, except to suggest
that fixed annuities be used to fund essential
purchases, while variable-payout SPIAs (not to
be confused with the previously discussed
"deferred" variable annuities-see how confusing
the industry's terminology can be?) should
cover lifestyle consumption. It is probably best
to skip the cost-of-living option, as that usually
comes at too high a price.
Longevity Insurance

The final use for annuities-assuming, as always,
that they are priced correctly-is for deferred
income. Should the retiree live longer than
expected, the payments from an advanced life
annuity could fill what would otherwise be
an income gap. Such annuities take the concept of
insurance in a different direction. In the case
of the advanced life annuity, the "problem" that is
to be insured is the event of living an unusually
long life. As problems go, there are worse! K
John Rekenthaler is vice president of research
with Morningstar Research Services.

4 Kitces, M. 2015. "Understanding the Role of Mortality Credits-Why Immediate Annuities Beat Bond Ladders for Retirement Income,"
https://www.kitces.com/blog/understanding-the-role-of-mortality-credits-why-immediate-annuities-beat-bond-ladders-for-retirement-income/ April 1.

Morningstar June/July 2018

https://www.kitces.com/blog/understanding-the-role-of-mortality-credits-why-immediate-annuities-beat-bond-ladders-for-retirement-income/

Table of Contents for the Digital Edition of Morningstar Magazine - June/July 2018