The Finance of Longevity

Deferred Income Annuity Purchases: Optimal Levels for Retirement Income Adequacy

Examining the impact of ‘decumulation stage’ risks: Longevity, health and investment

Excerpts from the whitepaper ‘Lifetime Income Solutions as a Qualified Default Investment Alternative (QDIA) –
Focus on Decumulation and Rollovers’ by Jack VanDerhei, Ph.D. for the Employee Benefit Research Institut (EBRI). Read the entire report here.

Modeling retirement income adequacy for non-retired U.S. households has often been split into an analysis of the accumulation phase (current age until retirement age) and the decumulation phase (retirement age until the age of death). In the last 15 years, the Employee Benefit Research Institute (EBRI) has conducted a significant amount of research on the impact of various accumulation-phase scenarios; however, only recently has an attempt been made to quantify the impact of the primary decumulation-phase risks: longevity risk, long-term-care and home-health costs, and investment risk.

As part of the assessment of the impact of longevity on retirement income adequacy, EBRI  used its Retirement Security Projection Model® (RSPM) to establish relative-longevity quartiles based on family status, gender, and age cohort. For the Early Baby Boomers simulated to die in the earliest relative quartile, the Retirement Readiness Rating (RRR)
of 75.8 percent was 19.1 percentage points larger than the overall average for this age cohort. The RRR decreased to 63.1 percent in the second relative-longevity quartile and 44.9 percent in the third relative-longevity quartile. For the Early Boomer cohort with the longest relative longevity, the RRR fell all the way to 37.9 percent. Similar influences were found for the younger age cohorts, but there was a noticeable increase in the RRR range between the earliest and latest longevity
quartiles: 37.9 percentage points for Early Boomers, 41.3 percentage points for Late Boomers, and 49.2 percentage points for Gen Xers.

While previous EBRI research has attempted to model single-premium immediate annuities (SPIAs) as at least a partial hedge against the longevity risk, given that only a very small percentage of defined contribution (DC) and individual retirement account (IRA) balances have been annuitized (and that an increasing percentage of defined benefit (DB) accruals have been taken as lump-sum distributions when the option was available), the prospect of “out-living” this portion of retirement wealth is a very real risk for many Baby Boomers and Gen Xers. In recent years, the prospect of increasing individual interest in annuitizing retirement savings at retirement has been enhanced through an insurance product that has been designed to provide monthly benefits only after a significant deferral period in retirement. These products could be offered for a small fraction of the cost for a similar monthly benefit through a SPIA and many believe that the lower cost would at least partially mitigate retirees’ reluctance to give up control over a large portion of their DC and/or IRA balances at retirement age.

Previous Research on Longevity Annuities

The concept of longevity annuities as a longevity hedge has been discussed for at least 10 years. In 2005, Milevsky  published a paper analyzing an inflation-adjusted, deferred-annuity contract that would begin payouts not at retirement age but at an advanced age (e.g., 80 or 85). In essence, this contract would attempt to apply basic risk-management principles to retirement planning and would carve out the highprobability/low-severity costs (e.g., retirement income from 65‒85) that could be budgeted relatively easily from the typical retirement scenario before transferring the low-probability/high-severity costs (e.g., retirement costs from 85 through the remainder of the retiree’s life) to the insurance company. This would be analogous to accepting a deductible on automobile insurance collision coverage and considered a more efficient method of choosing which risks (or portions thereof) should be transferred to an insurance company.

In 2007, Gong and Webb  attempted to deal with the fact that rates of voluntary annuitization remained extremely low by analyzing what would happen if longevity annuities were used as a 401(k) plan default. Realizing this had the potential to harm high-mortality households (relative to taking the 401(k) balances in unannuitized form), the authors used numerical-optimization techniques to show that few households would suffer significant losses under this type of default (as measured by the authors’ methodology).

In 2013, Pfau  demonstrated how deferred income annuities (DIAs) expanded the retiree’s “efficient frontier” and provided a case example of how these products could be more effective than a single-premium immediate annuity (SPIA) for a particular objective function...

In 2013, Pfau  demonstrated how deferred income annuities (DIAs) expanded the retiree’s “efficient frontier” and provided a case example of how these products could be more effective than a single-premium immediate annuity (SPIA) for a particular objective function.

In 2014, Blanchett used a utility-based, annuity-preference model to analyze the optimal form of guaranteed income and found that it varied substantially as a function of model assumptions and retiree preferences. He found that nominal SPIAs tended to be the most efficient of the eight annuity types analyzed; however, if nominal DIA-payout rates increased by just 5 percent, they became the most attractive option on average. In a 2015 article, Blanchett  used regression analysis on the optimal DIA allocation for each investor and found evidence that higher allocations would tend to be associated with
those who were younger and those who had less existing guaranteed retirement income.

Optimal Levels of Deferred Income Annuity Purchases for Retirement Income Adequacy

The objective of the new research for this testimony was to explore how the probability of a “successful” retirement varies with the percentage of the 401(k) balance that is used to purchase a deferred income annuity (DIA) where the probability of success is measured by the EBRI Retirement Readiness Ratings (RRR) from the EBRI Retirement Security Projection Model®. For purposes of these simulations, we use existing RSPM accumulation modules to simulate retirement income/wealth at age 65 for all US households between 35 and 64. Households with no 401(k) balances at retirement age are filtered out of the analysis and a retirement age of 65 is assumed.

The baseline stochastic decumulation module is run with an assumption of no annuitization (either SPIA or DIA) and sensitivity analysis on DIA annuitization by assuming various percentages (5, 10, 15, 20, 25, and 30 percent) of the 401(k) balance at retirement are used to purchase a DIA with 20 year deferral and no death benefit. We assume the percent and dollar constraints for current QLACs are not binding.

The percentage change in RRR from various DIA purchases at retirement by age at simulated death. As expected, anyone dying prior to age 85 (the end of the 20 year deferral period) would actually have their RRR decreased since they would have had a portion of their 401(k) balance used to purchase the DIA but had not lived long enough to benefit from it. For those dying before 85 and using only 5 percent of their 401(k) balance to purchase the DIA, the RRR would decrease by 0.3 percent. As expected, the RRR decrease is monotonically increasing as the percentage of the 401(k) balance used to purchase a DIA increases. At a 25 percent level the RRR decrease reaches 1.7 percent and at a 30 percent level it is 2.1
percent.

For those dying at ages 85-89, the difference between the cost of the DIA and the present value of the eventual benefits results in a decrease in RRR regardless of the percentage of 401(k) balance used but the decrease is less than that experienced for those dying prior to 85 for a 5 or 10 percent purchase but the decrease is greater than that experienced for those dying prior to 85 for 20, 25 and 30 percent due to the interaction with long-term care costs.

For those dying at ages 90-94, the increase in RRR is positive for all DIA purchases and the larger purchases have larger increases. This trend is repeated for those dying at ages 95-99. For those dying at ages greater than 99, the increase in RRR ranges from 4.0 percent for a DIA purchase equal to 5 percent of the 401(k) balance to 16.2 percent for a DIA purchase of 30 percent of the 401(k) balance.

When the results are aggregated across all ages at death (the last column in Figure 3), there is an increase in RRR for DIA purchases of 5, 10, 15 and 20 percent of the 401(k) balance but purchases of 25 or 30 percent result in a decrease in RRR.

 

Read the entire WhitePaper, ‘Lifetime Income Solutions as a Qualified Default Investment Alternative (QDIA) –
Focus on Decumulation and Rollovers’, here.