Annuity income has two properties that are rather similar to your work income.
Firstly, you are delegating the security of the stream of income to someone else. When you do that, you are placing your trust that the income will continue to someone else.
Secondly, unless you are in the sales line, your income tends to be rather predictable. (If you are in the sales line, in a way, you are less of an employee but you are more your own boss.)
These two properties make your work income very addictive.
There are people who do not like their job. Or they grew very tired after working for so long.
But their problem is that any other kind of income stream they came across:
- Do not give them enough security.
- Are not consistent enough.
Due to these two points, they do not have the courage to quit!
Those who are able to quit, despite not having an annuity income, did so because they:
- Genuinely found a strategy that can solve the two requirements of most people.
- Got swindled by some gurus in books, courses, or by themselves into believing their strategy solve the two requirements of most people. (A long laundry list of investing in retirement income plans, dividend investing, flexible spending strategy, living off crypto yield interest, buying high yield bond funds etc)
#1 will do OK. #2 will be in for a rude shock.
David Blanchett, the head of retirement research at QMA, and formerly from Morningstar, observed that this lack of trust and security has a big problem: Retirees without a non-annuitized income stream generally spend less than their income.
Seniors are too Frugal in Retirement
Browning et al (2016) find that there is a retirement consumption gap that ranges from 8% to greater than 50% depending on household wealth levels.
This gap persist even after adjusting for spending risks and retirees need to leave a legacy.
This affects the higher income as well.
De Nardi, French and Jones (2016) found that among the retired U.S households, especially those with high income, they spend down their wealth at a slower rate than the rate implied by a basic life-cycle model in which the time of dealth is known.
Some even accumulate more assets in retirement.
Banerjee (2018) research found that while most retirees do spend down their assets in the first 18 years following retirement, about 33% of all sampled retirees increased their assets over that period.
The Society of Actuaries (2020) interviewed retirees and noted that respondents wanted to maintain or increase asset levels, and this was to be accomplised primarily through cuts in spending.
We might attribute this under consumption to a variety of reasons such as
- desire to leave a legacy
- worried about uncertain medical expenses during late retirement
- uncertain life expectancy
However, Browning (2018) and Nordman et al. (2016) research finds that even after adjusting for explicit bequest motive and medical expenses, the amount of assets preserved is rather large.
I do think that the three reasons given above are a constant thorn or worry in those who are planning their wealth and financial independence.
But I think the main problem why retirees do not dare to spend is the lack of security, or the uncertainty of whether the income is consistent to meet their uncertain life expectancy.
The 2020 EBRI Retirement Confidence Survey finds that 2 in 3 households say they are preserving their assets in order to fund later-life expenses. Out of these, only 30% say they want to leave an inheritance.
Milevsky and Huang (2011) and Finke, Pfau and Williams (2012) determine that a retiree’s risk tolerance has an impact on their willingness to accept income shortfall.
- Risk-averse retiree prefer to avoid a possible drop in future spending and will spend less to ensure the longevity of their nest egg.
- Risk-tolerant retiree will accept the possibility of a shortfall and spend more in early retirement.
Spending less is a rational response of risk-averse retiree to accept the possibility of outliving savings.
Annuity Income Gives Retirees a License to Spend
What Blanchett and his research partner Micheal Finke, professor and chair of economic security at American College of Financial Services found is that annuities give retirees a psychological license to spend their savings in retirement.
Surveys reveal a clear preference among retirees to live off income and many don’t feel comfortable spending down assets to fund a lifestyle.
They find strong evidence that households holding more of their wealth in guaranteed income spend significantly more each year than retirees who hold a greater share of their wealth in investments.
A household with a generous pension and no savings will spend more than a retiree with enough savings to buy an annuity that provides the same income as the pension.
If they held the size of the wealth constant, they notice that households are spending more, not because they are wealthier, but rather it is THE FORM of wealth they hold that impacts spending in retirement.
Retirees will spend twice as much each year in retirement if they shift investment assets into guaranteed income wealth.
The Investor vs Executive Analogy
In Blanchett and Finke’s paper, they use this very interesting analogy to drive home the point of how a risk-averse retiree will use spending less as a natural response of not having enough money to last for their retirement.
They compare an executive versus an investor.
The executive must maintain a large position in a single stock (The interpretation is that his income is concentrated in the company he work for.) The investor can hold a well-diversified portfolio.
Holding a single stock means the executive’s portfolio can be very volatile, yet the expected return from his income does not significantly increase despite bearing with this greater volatility.
The expected welfare is lower compared to the investor.
The investor is liken to you transferring the longevity risk to an insurance company or an institution that allows you to live a better life by spending more each year.
The executive would be similar to the retiree who fails to transfer this longevity risk to an institution.
Some part of the analogy is a bit hard to understand but what they are saying is that if you have $1 million, deploying it in a Microsoft versus an annuity is very different.
Due to the volatility of Microsoft, you do not dare to spend a lot. So you control your spending. So let us say you spend only 3% of the initial sum.
However, with the same $1 million, deploying it with a insurance company and getting a single premium immediate annuity that yields 5%, you get to spend more today.
While it is true that there is less in bequest with the annuity, their argument is that the present value of both strategy is equivalent to $1 million.
The annuity give you greater welfare.
I do like the unintended part of that analogy.
We can be very concentrated in one property for our entire retirement income and spend our days having insecurity about the security of our retirement income.
Or we can be very diversified by investing in a broadly diversified ETF such as the IWDA or VWRA. They probably have at least 1,600 stocks so you do not have to worry about the security of anyone company.
In a way, the weakness of some businesses in IWDA or VWRA is buffered by other businesses that held up better. While your income may dip, it is better than a total collapse of your income should there be some supply and demand imbalance locally.
Income Security and Confidence
An annuity income stream worked better than an investment portfolio because even with an investment portfolio, we lack confidence the portfolio income will last us a lifetime.
And this lack of confidence will make us hold back and not spend so much.
Ultimately, in today’s world, most of us placed our income security in the hands of some employer or a third-party firm.
Our lack of confidence in our management sophistication made us trust others more than our own ability.
Many of us developed this lack of confidence in our own ability through years of investment mistakes.
Eventually, we turned to retirement income products that illustrated to us that they can give us annuitized lifetime income.
Or we turned to CPF LIFE.
Annuity’s four big advantages blends very well into a powerful strategy:
- Lifetime income
- When you pool a group of people together, the mortality credits boost your income payout to a level that other income products will find challenging to deliver
- Contractual obligation (depends on how tight this is)
- Transfer of management
The problem for Singaporeans is… other than our CPF LIFE annuity income, there aren’t any private immediate annuity plans.
There are a lot of retirement income products that looked like one.
But you can use this litmus test: can these retirement income products replace CPF LIFE?
CPF allows you to opt-out of CPF LIFE if you already have a lifetime annuity income stream that fits their criteria.
If the retirement income plan is a true blue annuity plan, then it should fit CPF LIFE’s criteria.
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Saturday 3rd of July 2021
Hi Kyith, many points you mentioned here are so easily relatable for me, a near-retire-but-too-scared-to-give-up-my-income person.
CPF Life is such a god-send, I max it out yearly to ensure I will have the highest possible payout when time comes. But, CPF Life alone is not enough, as you said, there aren't any good alternatives; I know a few insurance companies are sort-of, kind-of coming out with semi-annuity products through clever packaging but they are no way near the national program.
I thought about putting a lump sum into IWDA/VWRA and let it sit there for 20 years but then again I am in a unique situation where much of my spare cash are still in CPF (earning 2.5% and some 4%) for the next 20 years so those index investments suddenly not that attractive anymore for risk-averse person.
Sorry for the rant on a Saturday morning but again, thanks for the article and I hope you will bump into a good private annuity product soon and share it here.
Saturday 3rd of July 2021
@retirewithfi, thanks! That's what happened to me, I am over 55 and a fair amount of my "cash" are now in OA and SA. They will remained there for the next 20 years until I need to start draw down on them. Is this the best way to grow savings for 20 years? Well, it's the only way I know.
Saturday 3rd of July 2021
Hi I just want to add, CPF LIFE isn't the only 'annuity' available from CPF. Your SA and OA once adequately funded can act like annuities as well from 55 onward.