Research is supporting the fact that deferred annuities can help retirees ensure their savings will provide income for them for their entire lives, no matter how long that is.
The researchers looked at how annuities can protect against the downside of a long life – specifically the fact that the longer you live after retirement, the more money you need to pay your expenses. This is what retirement planners and insurance experts refer to as the risk of longevity.
What makes the risk of longevity confounding is it’s completely unpredictable; no one really knows how long he or she will live. So how do you plan for that?
A study by a private, nonpartisan, nonprofit research institute has concluded that deferred annuities can provide an effective hedge against retirees’ outliving their savings, a common fear among American workers who increasingly lack access to pensions.
Annuities Are Insurance Against Running Out of Savings
The research reinforces the main contention of annuity providers that the products are primarily insurance against the nightmare scenario of running out of retirement savings. They’re designed, in most cases, to provide a guaranteed stream of income that will last either a term of years or for the entire life of the annuity holder, depending on what type of annuity is purchased.
Annuities can also be modified to the specific needs of the purchaser through the addition of contract provisions known as riders.
Deferred annuities, as opposed to immediate annuities, are purchased with the idea of receiving income at a later time, years into the future. This allows the investment principal to build over time and increases the amount of the payments received by the annuity holder. Because of this, an income stream can be purchased for a lesser amount.
Effects of Using 401(k) Funds to Buy a Deferred Income Annuity
The Employee Benefit Research Institute explored how using a portion of a 401(k) balance to purchase a deferred income annuity (DIA) could affect the probability of a successful retirement, measured by the institute’s Retirement Readiness Rating, or RRR.
“We find that, at current annuity rates, purchases of a DIA at age 65 deferring 20 years with no death benefits result in an overall improvement in RRR (for all ages of death combined) for DIA purchases equal to 5, 10, 15, and 20 percent of the 401(k) balance,” said Jack VanDerhei, Ph.D., the institute’s director of research and author of the report. “However, there is an overall decrease in [retirement readiness] for DIA purchases equal to 25 and 30 percent — due in part to the interaction with long-term care costs.”
The study also found improvement in retirement readiness for purchases of DIAs using 5, 10 and 15 percent of the retiree’s 401(k) balances with a death benefit on the DIA. There was an overall decrease in retirement readiness for those who died before or soon after benefits could begin.
Those who live past the age of 89 would benefit significantly by the DIA purchase strategy, according to the findings of the report, which was titled, “Deferred Income Annuity Purchases: Optimal Levels for Retirement Income Adequacy.”
Lower income retirees rely to a greater extent on Social Security, the study says, and would benefit less from DIA purchases. Purchases using more than 5 percent of 401(k) balances would actually decrease retirement readiness in those households, the study says.
Annuities Raise Confidence, Reduce Stress
Income annuities also have beneficial psychological effects for retirees, according to new research commissioned by Principal Financial Group.
The research found that people who purchased annuities in combination with a traditional investment portfolio had more confidence and less stress in retirement than those who relied only on a traditional investment portfolio.
“Certainty provides confidence,” Wade Pfau, Ph.D., CFA, and Michael Finke, Ph.D., CFP, who conducted the research, said in their report. “This is one of the reasons that retirees who’ve incorporated income annuities into their retirement planning report higher levels of satisfaction.”
The researchers pointed to a University of Michigan study that looked at roughly 20,000 older Americans and found that higher levels of guaranteed income in retirement correlated with greater satisfaction in retirement.
The report quoted an annuity owner as saying, “One of the best things about an annuity is that you know your basic expenses are always going to be covered. … We don’t want to be stressed every month at this point in our life.”
A common fear about buying an annuity is not being able to leave money to your loved ones. However, the researchers concluded that people with annuities felt more able to leave money for their heirs or a charity once they knew their expenses would be met by the guaranteed income of an annuity.
Pfau and Finke talked to annuity owners and concluded that income annuities are less expensive and safer for retirees who are reluctant to take risks.
“Income annuities allow a retiree to spend at a level that investments alone couldn’t match without significant risk of running out of money before age 95,” according to a summary from Principal.