Annuities are Great, In Theory
I was listening to Episode 89 of the Rational Reminder podcast, an interesting interview with Wade Pfau who is an expert on retirement income. Much of the discussion was on annuities. This made me reflect on the challenges of using annuities in Canada.
Pfau speaks highly of Moshe Milevsky, and both have done work showing how retirees can use their portfolios more efficiently in retirement if they put some of their money into annuities. Another expert in the same camp is Fred Vettese who advocates buying an annuity with about 30% of your savings.
The math checks out on the work these experts have done to show that you can spend more from your portfolio with less risk of ever running out of money if you use annuities. However, the underlying assumptions need to be examined.
Pfau says investors just don’t like handing a big chunk of their money over to an insurance company, even though buying an annuity is very helpful for dealing with longevity risk. It’s quite true that some people are irrational in this regard.
So, we’ve established that annuities are a great idea in theory. What about practice? The biggest problems with annuities in Canada are inflation and an inefficient market.
I’m not aware of any insurance company in Canada that will sell a CPI-indexed annuity. You can get annuities whose payouts rise by a fixed percentage each year, such as 2%, but they’re not CPI-indexed like CPP or OAS payments.
So, is this lack of inflation protection a big deal? Yes, it is. Several older members of my extended family saw their fixed annuity payments decimated by the high inflation of the 70s and 80s. Nobody knows if or when this will happen again. To ignore the possibility of high inflation over a 30- or 40-year retirement is a big mistake.
Another problem with annuities in Canada is getting prices. It’s possible to find online comparisons of immediate fixed-payout annuities, but I haven’t been able to find payouts for annuities whose payments increase each year. Apparently, for that you have to go talk to a salesperson.
This market inefficiency makes it harder to get a good price and lowers payouts. When retirement income experts do the analysis to determine the optimal amount of your money to put in annuities, they make assumptions about payout levels and inflation. Optimal annuity amounts are quite sensitive to payout levels. They are even more sensitive to treating inflation as a random variable where high inflation is possible.
Protection from longevity risk is important. We need access to OAS- and CPP-like annuities that increase payments by inflation each year. This would certainly reduce initial monthly payments, but would give a more honest view of what an annuity can really pay. At present, annuities are great in theory, but not as good in practice.
Pfau speaks highly of Moshe Milevsky, and both have done work showing how retirees can use their portfolios more efficiently in retirement if they put some of their money into annuities. Another expert in the same camp is Fred Vettese who advocates buying an annuity with about 30% of your savings.
The math checks out on the work these experts have done to show that you can spend more from your portfolio with less risk of ever running out of money if you use annuities. However, the underlying assumptions need to be examined.
Pfau says investors just don’t like handing a big chunk of their money over to an insurance company, even though buying an annuity is very helpful for dealing with longevity risk. It’s quite true that some people are irrational in this regard.
So, we’ve established that annuities are a great idea in theory. What about practice? The biggest problems with annuities in Canada are inflation and an inefficient market.
I’m not aware of any insurance company in Canada that will sell a CPI-indexed annuity. You can get annuities whose payouts rise by a fixed percentage each year, such as 2%, but they’re not CPI-indexed like CPP or OAS payments.
So, is this lack of inflation protection a big deal? Yes, it is. Several older members of my extended family saw their fixed annuity payments decimated by the high inflation of the 70s and 80s. Nobody knows if or when this will happen again. To ignore the possibility of high inflation over a 30- or 40-year retirement is a big mistake.
Another problem with annuities in Canada is getting prices. It’s possible to find online comparisons of immediate fixed-payout annuities, but I haven’t been able to find payouts for annuities whose payments increase each year. Apparently, for that you have to go talk to a salesperson.
This market inefficiency makes it harder to get a good price and lowers payouts. When retirement income experts do the analysis to determine the optimal amount of your money to put in annuities, they make assumptions about payout levels and inflation. Optimal annuity amounts are quite sensitive to payout levels. They are even more sensitive to treating inflation as a random variable where high inflation is possible.
Protection from longevity risk is important. We need access to OAS- and CPP-like annuities that increase payments by inflation each year. This would certainly reduce initial monthly payments, but would give a more honest view of what an annuity can really pay. At present, annuities are great in theory, but not as good in practice.
Yes inflation can ruin the value of annuities, but the same holds true for bonds.
ReplyDeleteHi Garth,
DeleteYes, but to differing degrees. I buy only short-term bonds to minimize inflation risk. 40 years of annuity payments necessarily take on substantial inflation risk. The amount of risk matters.
Don't annuities also bring credit risk into play and reduce diversification? Isn't putting 30% of your savings into an annuity with one (or two) companies conceptually the same as putting 30% of your savings into one or two stocks?
ReplyDeleteJ.K. Reid: It's not the same because of Assuris, a consumer protection agency that backs the first $2000/month plus 85% of the rest. Check the following page:
Deletehttps://www.canada.ca/en/financial-consumer-agency/services/retirement-planning/annuities.html
I agree with your points Michael, and I agree that CPP and OAS-like annuities are the only reasonable options in Canada.
ReplyDeleteThe best way to buy these types of annuities is to use savings early in retirement to defer these benefits in exchange for higher payments. This could be considered "buying" more CPP and OAS.
Returns Reaper: I agree that delaying taking CPP and OAS makes a lot of sense. This is effectively like buying more of a "good" annuity. Unfortunately, I can't buy as much as I'd like that way.
DeleteDelaying to age 75 for even higher payments would be great. Although it might trigger widespread unhappiness if people who took CPP at 60 and OAS at 65 found out how much people who waited until 75 were being paid.
Yes, I agree. I anticipate (ideally) wanting quite a bit more annuity in retirement than I'll be able to "buy" by delaying CPP and OAS. I'd happily delay further if it was allowed in order to "buy" more. I'd also buy more from an insurance company if there was a competitive market place for the right kind of annuity, but sadly, as you point out, it doesn't seem to exist in Canada.
DeleteI think my view is probably the same as yours. Buy as much of the "good" annuity as possible, and fund the remaining from your portfolio.
I'm probably ~20 years from retirement so I suppose it's possible the marketplace might change for the better. Unfortunately that seems to rarely occur without government intervention and I don't see the government getting involved here.
Returns Reaper: A big problem in the annuity market is that tricking people with non-inflation-adjusted annuities works (among those interested in annuities at all). Not enough people understand the damaging effect of inflation enough to choose a much lower starting payment in return for future inflation protection.
DeleteI am a neophyte to annuities. I plan to retire at the end of 2020 as I will be 65 in October. I also plan to not take my CPP and possibly my OAS until age 70. I was thinking of following Fred Vettese's advice about buying an annuity early on, and I think he advocates taking your OAS at 65 as well. (I have his book on order) But, now that I read about annuities being non-inflation adjusted, I will have to rethink the whole thing. I am not sure what you mean by choosing a much lower starting payment in return for future inflation protection. I would welcome any input from you in this regard. Thanks
DeleteHi Nancy: You can get an annuity whose payments increase by a fixed amount each year, such as 1% or 2%. This isn't exactly inflation protection, but it helps some. You'd still be exposed to the risk a period of high inflation in the future, but the fixed percentage increases would help. The downside of getting an annuity with these percentage increases is that the starting payout is lower. But I'd prefer this over watching the purchasing power of my annuity payments erode. Hope this helps you decide what to do.
DeleteIt seems almost funny to criticize annuities when there are probably a lot of seniors who wish they had them right now. Its not like Wade Pfau is advising people to put all their money in annuities. Still, its good to be aware of the inflation risk.
ReplyDeleteChristina: Wade Pfau and others advise having a "safe" base of income in an annuity. However, this base isn't safe. If they repeat their analyses allowing for the possibility of a period of high inflation, they'll get different recommendations.
DeleteAlso, weren't interest rates high in the 80s so you would have high annuity rates? There is probably a period of time it wasn't beneficial to hold stocks either. I imagine the 1930s. There are pros and cons to every investing strategy. I would still think having a balance of annuities, fixed income and equities would be best so you are not reliant on any one thing.
ReplyDeleteChristina: You're missing the point. Getting an annuity during a period of high interest rates isn't the problem. It's getting the annuity before interest rates and inflation rise.
DeleteAnnuities and long-term bonds suffer from the same risk: an increase in inflation. So, annuities must bring enough protection from longevity risk to justify their low payout rates in Canada. It's not clear that they do.
Another risk Wade Pfau identifies is low cognitivity risk. As a single female that is of particular concern for me and i am not ruling an annuity out for that reason but would rather mitigate the risk by buying an annuity at 70 or aldas. I don't believe there is one cookie cutter approach to retirement. As Pfau identifies there are different risks like sequence of return risk, longevity risk and spending shock risk. All we can do is mitigate the risks as best we can. Thanks for the thought provoking post though. I paid the 10.00 for Pfau's book and will check out Bernstein's. You are right we need to be careful on applying these american solutions to canadian situations though.
ReplyDeleteChristina: By "low cognitivity risk," I assume Pfau is referring to the risk of declining cognitivity as we age. This is certainly a real risk. A closely-related risk is our inability to make good choices, even before we age. Insurance companies exploit our poor understanding of inflation by selling us non-indexed annuities. If you're going to buy an annuity at some point, I suggest looking at one that increases payments annually by a percent or two. This will decrease the starting payout, but will slow the inevitable decline in your standard of living that even low inflation will cause. Of course, there is still the possibility of high inflation to significantly reduce the buying power of annuity payouts. But at least the 1% or 2% annual increases would blunt inflation somewhat.
DeleteThanks. I didn't know that was possible.
ReplyDeleteIncidentally, for those reading Pfau's book is 10.00 as an amazon kindle and bernstein's deep risk is 5.00 as a kindle.
ReplyDeleteExcuse all my posts, i wanted to post this article on indexed annuities for those interested https://retirehappy.ca/indexed-life-annuity/
ReplyDeleteChristina: I think I've seen this post (or one like it) before on Retire Happy or elsewhere. We need more like it to open people's eyes to the idea of indexing their annuities. Even better would be if people started to demand indexing linked to inflation.
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