When it comes to annuities, it's head versus heart

July 21, 2021

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It's hard not to like guarantees. That's why they're featured so prominently in ads for everything from refrigerators (parts and labor guaranteed!) to vacation rentals (if you're not 100% satisfied, we'll refund your money!).

Of course, the value of such guarantees can be dubious, often coming with a list of exceptions a mile long.

It's a different, more complicated story when it comes to annuities.

For participants who expect to live longer than the average life span, the math appears compelling: A guaranteed income can leave retirees better prepared, according to the Vanguard paper Guaranteed Income: A Tricky Trade-Off.

But the math is less convincing for participants who expect an average life span, particularly given the enormity of the emotional hurdles involved in buying an annuity.

Understanding the math

We analyzed the financial impact of annuitization on income and wealth through retirement. We started with an analysis of an immediate income annuity (a single premium immediate annuity [SPIA] and of a deferred fixed income annuity (a qualified longevity annuity contract [QLAC]).

Consider the effect of partial annuitization on an investor's success in meeting a $40,000 real spending target. Over periods of up to 25 years, the combination of a SPIA and an investment portfolio produces a slightly better chance of meeting the $40,000 real spending target than does an investment portfolio alone. Meanwhile, at longer horizons, a QLAC leads to higher success rates.

Comparing success rates in meeting a $40,000 spending target over time

Comparing success rates chart

Notes: The asset allocation for the investment portfolio is 60% U.S. stocks and 40% U.S. fixed income. See "Index simulations" in the Important information section below for more details on these asset classes. The forecast success rates in meeting the $40,000 real spending target are based on 10,000 simulations of Vanguard's return projections for 20 to 35 years. The annuity payout is based on the quote for a SPIA, with no survivor benefits, for a 65-year-old male on February 3, 2021.

IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model® (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modeled asset class. Simulations are as of June 30, 2020. Results from the model may vary with each use and over time. For more information, see the Important information section below.

Sources: Vanguard and Hueler Companies.

Such numbers show that a mathematical case can be made for annuities—particularly QLACs, which our simulations suggest are more effective as insurance against longevity risk, replacing a larger share of target income at advanced ages. But annuity use—both of SPIAs and QLACs—continues to be low.

What's going on?

Understanding the role of emotions

Longevity risk cuts two ways. Annuities are attractive as income protection for a long life, but they are anxiety-provoking when faced with the possibility of a shorter life and the exchange of liquid assets for an illiquid contract with an uncertain payoff. Such apprehension is understandable.

An annuity purchase—SPIA or QLAC—leads to an immediate decline in the liquid wealth accumulated over a lifetime of labor. This presents a psychological barrier. While attractive at first, writing that "big check" and parting with a sizable portion of the nest egg they've spent 40-plus years accumulating for something that may not pay off for years can be too high a hurdle for many participants.

Accepting a supporting role

That's not to say an annuity can't be a viable retirement income option. But given participants' understandable wariness, an annuity shouldn't be the primary—and certainly never the only—option they are given, writes Colleen Jaconetti, a senior investment strategist in Vanguard Investment Solutions, in her blog post Retirees and the Curb Appeal of Annuities.

We believe a better approach to retirement income is to offer a spectrum of products, solutions, and experiences as part of a comprehensive offer that allows plan sponsors to meet the unique retirement income goals of individuals. By taking such a wholistic approach, we can provide the portfolio, financial, and emotional value necessary to support the complete scope of a participant's financial well-being.

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Notes:

Important information

  • All investing is subject to risk, including the possible loss of the money you invest. Annuity guarantees are subject to the claims-paying ability of the issuing insurance company. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your investment portfolio. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
  • The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
  • The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard's primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
  • Index simulations: The long-term returns of our hypothetical portfolios are based on data for the appropriate market indexes as of June 30, 2020. The asset classes and their representative forecast indexes are as follows: for U.S. equities, the MSCI US Broad Market Index Global; for U.S. bonds, the Bloomberg Barclays U.S. Aggregate Bond Index.