On top of running investment and longevity simulations against investment-only portfolios, the study also explores the sentiment of retirees that are living, in part, off income from annuities. (Photo: Shutterstock)

The measure of a culture's values can be gauged by how well it cares for its young and for its old, thinks Sri Reddy.

For the latter's security, guaranteed retirement income is critical, says Reddy, who recently moved to Des Moines-based The Principal to lead its annuity and pension risk transfer units.

“Who are the people not worried about running out of money in retirement? It's the ones that are covered by pensions—they're smiling cheek to cheek,” Reddy told BenefitsPRO.

Where pensions aren't available, annuities can step in to fill the void, he says. “My fundamental belief is that when people don't have some annuitized income on top of Social Security, they end up penny pinching.”

And that creates stress, along with heightened longevity and investment risk, according to a new study commissioned by The Principal and authored by Michael Finke and Wade Pfau, PhDs at the American College of Financial Services.

The academics compared the retirement outcomes of portfolios that included an income annuity with 10,000 Monte Carlo simulated returns on traditional stock and bond portfolios.

Assuming a long retirement—the simulations were tested for retirees reaching age 95—the research found that combining an income annuity provided better financial returns than an investment-only approach.

Portfolios with partially annuitized savings created at least as much income as investment-only portfolios in some scenarios, and more income in others. And annuitization dramatically reduced the risk of outliving savings over a long retirement.

Finke said this latest research adds to decades' worth of studies proving the value of partial annuitization in creating retirement income streams.

“There's no argument in the academic literature,” said Finke. “Since 1960, we've known annuities provide higher and safer income by pooling retirees' resources. It's pretty well settled that annuitization is the most efficient way to create retirement income.”

Finke and Pfau's research considered income annuities, where premiums are invested in an insurance company's general fund. That the annuities succeed in better managing longevity risk by creating lifetime income streams is hardly surprising.

But less obvious was their role in addressing market risk. By partially annuitizing savings, retirees' remaining portfolios can assume more risk and capture upside returns.

That ability could prove vital to retirees going forward, said Phau.

“In the investing world, the thinking is the stock market will perform well enough to sustain savings. But the consensus is we should be expecting lower returns from stock markets going forward,” said Phau.

'Annuity' in need of PR makeover

For some money managers and consumer advocates—and perhaps some regulators—annuities have long been a soft target.

That's had an impact on retirement savers' impression of the products, but not with their interest in guaranteed retirement income.

“Guaranteed income really resonates with people, but the minute you use the word 'annuity', people turn negative,” said Reddy, who described fixed annuities as The Principal's “bread and butter” among its guaranteed income offerings.

For academics, the focus has been less on challenging the efficiency of annuities to create income and more on understanding what Finke calls the “annuity puzzle.”

“They're unquestionably the right way to create income for risk-averse retirees, but the question is why don't more people buy them. That's the focus of recent annuity research,” he said.

Fear and a general lack of awareness have been barriers to wider utilization of income annuities.

“If you give near-retirees the option to allocate a percentage of a nest egg, most will choose to allocate something to guaranteed income,” said Finke. “But most people don't understand what an annuity is, which is something I hope industry pushes hard to improve in the future. We need to overcome the awareness barrier, and collectively make that a priority to improve consumer understanding.”

For higher-net-worth investors, much of annuity consumption has been for tax purposes, a reality that has kept the larger market of retirement savers from understanding annuities as a pension-like stream of income.

“The preferential treatment in the tax code led to annuities to be used for tax deferrals, and not lifetime income,” explained Pfau. “All annuities have to offer an annuitization option, but that was in the background, and not always a consideration.”

The Labor Department's fiduciary rule, vacated by an appellate court in 2018, took a toll on annuity sales in the run up to its implementation. Under the rule, variable and fixed index annuities were subject to the rule's requirement to give investment advice on qualified retirement assets that is solely in investors' best interest.

While slowing annuity sales were seen as the rule's implementation drew closer, Finke doesn't think it was the Labor Department's intention to tarnish the annuity name.

“I don't think Labor intended to injure annuities,” he said. “But it was interpreted by many that avoiding commission-based products would give safe harbor from the rule.”

The commission-based model under which the vast majority of annuities are sold makes sense, Finke and Pfau said.

“If you consider annuities as a set it-and-forget-it product, there really only needs to be a single transaction cost, and a commission is a better way to compensate the advisor for recommending a product if the advisor isn't providing ongoing advice,” explained Finke.

Increasingly, insurance companies are offering fee-based annuities through existing registered advisor channels or third party platforms.

The products strip commissions, can be offered without surrender charges, and are a clear effort to make the annuities attractive to fee-only advisors.

“You can make an argument that an advisor might hesitate to recommend an annuity as an investment strategy if they were not allowed to receive compensation for managing the assets,” said Pfau. “There shouldn't be disincentives for annuity recommendations.”

License to spend

Finke and Pfau found the pricing of income annuities to be “surprisingly” attractive, given the size of the market.

On top of running investment and longevity simulations against investment-only portfolios, the study also explores the sentiment of retirees that are living, in part, off income from annuities.

“It became clear they saw the annuity income as part of their monthly budget,” said Finke. “And they felt no guilt about spending that income. It gave them license to spend because they weren't worried about running out of money.”

They were also more comfortable assuming investment risk with other assets, because they're not pulling money out of IRAs.

In using annuities to fund inflexible retirement expenses—out-of-pocket health care costs, or property taxes, as an example—partial annuitization proved to create far more income per dollar than investment-only strategies.

Beyond the paper's quantitative research supporting partial annuitization, the research also found that those with $100,000 in investable assets had a larger remaining nest egg if they reach age 95 under good and average market conditions.

“That result was surprising,” said Pfau. “Because people have tended to assume that annuities reduce the legacy value of savings.”

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