As plan sponsors educate themselves on the range of retirement income options available today, they should think about annuities in simple and straightforward terms as a product that can help their participants manage longevity risk, said Benjamin Goodman, Vice President at TIAA. People get caught up in the complex terms and acronyms of different annuities, but basically, annuities serve people who want protection from outliving their savings, added Goodman, speaking at Pensions & Investments’ Retirement Income Virtual Series’ session on ‘Demystifying Annuities’. “My goal, in fact, is to try and demystify annuities. That’s almost in my job description!”
Goodman uses the analogy of a mortgage to explain annuity pricing. “You go to the bank to borrow money, and the bank officer says, ‘You need $100,000? You have to give me $422 a month.’ That number is based on two factors: the mortgage interest rate the bank charges you – the higher the rate, the more you pay; the lower the rate, the less you pay — and the term of the mortgage. The longer the term, the less you pay (30-year mortgage), the shorter the term, the more you pay (a 15-year mortgage) he explained.
“Annuities are similar, except you're the bank. You give the insurance company money, and they pay you back. The higher the interest rate environment, the more you get. The lower the rate, the less you get. And the term is based on your age. If you're very young, the term will be a long time, and the less you get. If you're very old, the term is shorter, and the more you get. That's how annuities are priced. I won’t get into the formulas. But that's the concept: it’s pretty straightforward.”
Goodman shared a ‘Twin Sisters’ story to illustrate why someone would want an annuity. Twins named Tara and Rachel walk in the door at the insurance issuer. Both are 65 and have $100,000.” Tara says, ‘Here's my $100,000. How much are you going to give me?’ Based on a 3% adjusted interest rate and an assumed mortality—using an SOA (Society of Actuaries) table that says the average person lives to 89 years—I tell Tara, "For your $100,000, I will give you $500 a month or $6,000 a year for the rest of your life. So Tara’s out the door, happy to get the check for rent each month," said Goodman.
“Rachel wants to invest the same way Tara does, in a fixed investment that earns 3% interest, but she does not want to annuitize. She takes out $500 a month, or $6,000 a year, from her account balance. It should be obvious, when she’s earning 3% on $100,000 and pulling out $6,000, she’s taking more than she’s earning. Her account balance starts decreasing and one day, there's no balance left. When is that day? It's age 87 when Rachel runs out of money,” he said.
“That's the entire annuity story. An annuity can be a good idea if you live past 87 because your rent still gets paid. But if you’ve done withdrawals, you could be living in a cardboard box eating cat food in the park. If you die before 87, the annuity was possibly a bad idea because Tara left her kids no money. On the other hand, Rachel still has money left.”
Plan sponsors should look at an annuity as a way of providing their participants with access to insurance that addresses that longevity risk, Goodman said. “It's the only insurance in the world where you get to enjoy your victory (living long),” he said, adding “It's very, very hard to try to plan for how long you have. The whole point of the annuity is to help do the planning for you.” Participants should generally not annuitize all their assets, just a portion of them in order to protect against longevity risk, he said.
Most of TIAA’s institutions, non-profits, colleges and universities across the U.S., have annuities on their 403(b) plan menus. Goodman expects to see more interest in custom solutions, along the lines of what one of their clients, Yale along with consultant Aon, introduced last year: a fixed annuity in the target date fund default option.
“This was, in fact, a solution where you get the best of both worlds: a target-date-fund-like structure with more equity investment early on and less equity investment later on. He says over 75 institutions, both large and small, have moved to adopt the custom fixed annuity within the target date structure.1
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