• Global Home
• My Watson Wyatt
• Contact Us
• Investor Relations
• Careers

Market Payouts From Immediate-Life Annuities: Trends and Volatility

Popular discussions of the shift from defined benefit plans to defined contribution and other individual account plans have thus far focused mainly on differences in risks, returns and flexibility during the benefit accrual/asset accumulation phase of the retirement cycle. As the baby boom generation begins to retire, however, the zeitgeist will follow the money, focusing on differences in risks, returns and flexibility at the other end of the retirement cycle, when distributions begin in earnest. Under traditional defined benefit plans, retirees receive an automatic and definite level of lifetime payouts based on a fixed accrual formula, regardless of financial market conditions (although some defined benefit plans also offer a lump sum payout, and many retirees take it). By contrast, most defined contribution plan participants are left to figure out a distribution strategy on their own, and they continue to be vulnerable to the ups and downs of financial markets in their retirement years. 

Research shows that one of the most effective ways to reduce the risk of outliving one’s assets is by converting at least some of those assets to a fixed-life annuity. To do so, a defined contribution plan participant could use her account balance to buy a single-premium immediate annuity (SPIA) in the commercial marketplace. But the open-market cost of annuities is volatile, making such purchases subject to considerable timing risk, as we show below. In addition, we demonstrate that, as interest rates have declined over the past two decades in the United States, the purchasing power of a set account balance has similarly declined. And, unlike in pension plans — since a 1983 Supreme Court decision mandated equal benefits for men and women — women must pay more than men do for life annuities in the commercial market.

Policymakers around the world have been discussing the costs and benefits of mandating annuitization of defined contribution plan balances, but oftentimes without delving into market specifics and their effects on retirees’ incomes. Under the recently passed Pension Protection Act of 2006, sponsors of defined benefit plans must calculate lump sum distributions using a corporate bond yield curve rather than long-term Treasury rates. Because corporate bond ratesare almost always higher than long-term Treasury rates, lump sums are likely to go lower. When these issues emerge into public awareness, as they surely will, the great value and benefit found in the annuity distribution from traditional defined benefit plans will be demonstrated anew. Our analysis uses a simple pricing model for SPIAs, which is based on the projected mortality of purchasers of individual annuities, by gender, and the ever-changing term structure of interest rates. A few insurer issuers of SPIAs use this same approach to pricing, and research has confirmed that it closely approximates the practices of all issuers, as indeed it must in a competitive commercial market for insurance products and financial instruments.

Figure 1 below shows the fixed monthly payout from the model-simulated SPIAs issued to 65-year-old men, women and couples for a single premium of $100,000 from January 1983 through May 2006. More specifically, changing fixed lifetime monthly payments (in nominal terms) are shown for SPIAs (with guaranteed periods of 10 years for individuals and 20 years for couples) bought for $100,000 at the end of the month. 

Reading the chart, we can readily discern three important facts: (1) Monthly payouts from SPIAs have declined over time. For example, in June 1984, a $100,000 premium bought a monthly payout of $1,141 for a couple. By May 2003, however, as interest rates fell to secular lows, the same $100,000 bought only $515 in monthly benefits. By May 2006, $100,000 bought a slightly higher monthly payment of $584, as long-term rates have remained relatively steady, albeit low, during the last four years or so, even as the Federal Reserve raised short-term rates significantly. 

(2) Monthly payouts to women are lower than those to men for the same premium. For example, in May 2006, a male retiree would receive $699 monthly versus $656 for a woman, because women’s life expectancy is longer than that of men. (3) Buying a SPIA carries considerable timing risk. For example, from June 1984 to June 1985, the monthly lifetime payments a couple could buy for $100,000 declined from $1,141 to $926 — $2,580 a year.  Figure 1 also shows a formal measure of the volatility of SPIA payouts over this time period.  The standard deviation, which measures the dispersion of a series of numbers around the mean, in the same unit of measurement as those numbers, was calculated to measure timing risk. For the joint-and-survivor SPIA, for example, the standard deviation is $139, meaning that across this time period, changes of that magnitude from the average were fairly common and well within the range of experience.   

Perhaps a more intuitive way of conveying volatility is by subtracting the monthly payouts from SPIAs purchased in a particular month from the payouts from SPIAs purchased one year earlier and calculating the percentage change. For example, assume that Jane bought a SPIA for herself and her husband with $100,000 from her 401(k) account at age 65. Mary, who worked in the office just next door for many years, also retired at age 65 and bought a SPIA for herself and her husband just one year earlier. (This is a fairly direct way of measuring regret arising from timing risk.) This measure of volatility is shown in Figure 2.

Looking at the chart, we see considerable volatility (and scope for regret). By waiting one year — from March 1985 to March 1986 — Jane lost 27.8 percent in monthly income compared to her former colleague, Mary. In May 2006, by contrast, Jane beat Mary by 10.8 percent, as the Fed’s policy of rate increases finally affected long-term interest rates somewhat. (Even more recently, at the time of this writing in early October, long-term rates have come down again, as oil prices have retreated and the housing market has softened!)

There are, of course, methods for dealing with this type of risk. But these methods have their drawbacks as well. For example, one could reduce the timing risk by phasing withdrawals from the defined contribution plan over a few years. But this approach requires discipline, liquidity and knowledge. Another way to manage timing risk would be to defer annuitization until interest rates peak. This approach perhaps requires even more discipline, liquidity and knowledge than the first one. 

Alternatively, the plan participant could reallocate assets as retirement draws near, shifting more assets to bonds, whose prices move inversely to interest rates. This is the defining feature of life-cycle funds. But, of course, at least in expectation, this method sacrifices return for the lowered risk, as compared to the steadier asset allocations held by defined benefit plans. Variable immediate annuities, whose monthly payouts vary with returns on a participant-chosen underlying asset portfolio, avoid the point-in-time risk of fixed annuities. The downside, however, is pushing income volatility risk toward the end of the life cycle, where it may be particularly hard to bear. And a few plan sponsors allow participants to transfer their 401(k) account balances to the defined benefit plan, sometimes on favorable terms, thus securing a life annuity with a fixed payment level. This approach helps avoid marketing costs, but still generally leaves interest rate risk to the plan participant.