Unlike most investing products, life annuities actually solve a problem that do-it-yourself investors have difficulty handling on their own: longevity risk. By controlling my own investments with low-cost index ETFs, I can beat most professionally-managed mutual funds. However, when it comes to my retirement years, it will be hard to decide how much money it’s safe to spend because I don’t know how long I’ll live.
If you control your own investments, the only practical approach in your retirement years is to spend little enough that your money will last to the end of a very long life. Just because the odds are only, say, 50% that you’ll make it to age 80, that doesn’t mean that you can get away with saving only half a year’s worth of spending money for your eighty-first year. If you make it to age 80, you’ll need a whole year’s worth of money.
Life annuities are an insurance product designed to solve this problem. The insurance company takes a lump sum of money from you and pays you a monthly amount for the rest of your life, no matter how short or long your life turns out to be. This transfers the longevity risk from you to the insurance company. It also eliminates any inheritance.
The insurance company reduces risk by selling many life annuities. They can predict with reasonable certainty how many people will live to each age. So, if only half the people will make it to age 80, the insurance company will only have to pay half as much by then. The savings the insurance company expects over time allows them to increase the monthly payments everyone gets right from the first month.
So, with the longevity risk significantly reduced and with everything else being equal, a life annuity allows you to spend more each month than if you handled your own investments. Unfortunately, everything else isn’t equal. Insurance companies have to pay executive salaries and salespeople’s commissions somehow. These costs come out of the lump sum you hand over to the insurance company when you buy the life annuity.
Another factor is that the insurance company might not invest the money the same way that you would. If they are conservative and use mostly fixed-income investments, then you’re very likely to get less than if the money were invested in stocks.
Overall, I don’t have an answer to the question of whether a life annuity is better than investing on your own throughout retirement. But, I tried to come up with a way to have your cake and eat it too. By this I mean can we reduce longevity risk and cut out all the hefty fees and commissions?
One possibility is to pool retirement funds with other individuals to spread out longevity risk. Suppose that 20 people pool their money. At first withdrawals are split 20 ways, but as the participants die off, the withdrawals get split 19 ways, then 18 ways, and so on. The idea is that after you die, your share goes to the survivors.
It’s all a bit morbid, but it could work out well if there aren’t any serious conflicts. Draining the money to pay lawyers over a squabble would be a problem. Another problem that might make an interesting movie is that each person would have a financial incentive to bump off the others.
Despite what many people seem to believe, individual investors with a little knowledge can usually get better returns than the professionals. Reducing longevity risk is one of the few significant ways that professionals handling big piles of money have an edge over the little guy.