Rational Decumulation Summary

Wharton Financial Institutions Center

Policy Brief: Personal Finance

Investing Your Lump Sum at Retirement

The Wharton Study – University of Pennsylvania, School of Business

Professor David F. Babbel of The Wharton School and Professor Craig B. Merrill of The Marriott School of Management at Brigham Young University

Two-year In-Depth Study of Fixed Indexed Annuities

Six Ph.D. Economists & Two Senior Actuaries

• “Since inception in 1995 many FIA’s have outperformed corporate and government bonds, equity mutual funds, and money markets in any combination.”
• “Not in a year here and there but in every year!”

As Americans grapple with the challenge of potentially outliving their retirement savings, a new Wharton School study has found that lifetime income annuities (FIA) are the most cost-effective and secure asset class for generating guaranteed retirement income for life. The study also found that income annuities (FIA) can provide secure income for one’s entire lifetime for 25-40% less money than it would cost to provide a similar level of secure lifetime income through traditional means.

The research finding, co-sponsored by the Wharton Financial Institutions Center at the University of Pennsylvania and New York Life Insurance Company, are outlined in a paper entitled “Investing Your Lump Sum at Retirement,” which is based on an academic study co-authored by Professor David F. Babbel of The Wharton School and Professor Craig B. Merrill of The Marriott School of Management at Brigham Young University. The study explores financial options for retirees and compares income annuities with other asset classes in retirement.

Dueling Asset Classes: The Wharton Study

DEMONSTRATES THAT LIFETIME INCOME ANNUITIES (FIA) ARE THE BEST ASSET CLASS FOR FINANCIAL SECURITY IN RETIREMENT

Income Annuities Top Other Asset Classes By Mitigating Risk of Outliving Retirement Savings

The Wharton academic study revealed that:

• Income annuities (FIA) can provide secure income for one’s entire lifetime for 25-40% less money than it would cost an individual to provide a similar level of secure lifetime income through traditional means, thanks to an insurer’s ability to spread risk across large numbers of people;
• Consumers are not annuitizing enough of their portfolios even though income annuities are low-cost, available from creditworthy insurers, and provide guaranteed payments for life. Equities, fixed income, and other investment products like mutual funds carry the risk of outliving one’s nest egg;
• By covering at least basic living expenses with income annuities (FIA), consumers have much greater flexibility in other areas of a retirement plan, including the ability to take more investment risk with the remaining portfolio;
• Recent innovations in income annuities, such as annual inflation adjustments, legacy benefits, and access to capital in emergencies, have helped elevate the product to a desirable asset class in retirement.

“Living too long is fast becoming the major financial risk of the 21st century,” said Professor Babbel. “Combined with the challenges facing Social Security and the decline of corporate pensions, this adds up to a ‘perfect storm’ for retirees who might outlive their retirement nest egg. Compounding our concern is that those who have chosen to annuitize their wealth through private annuity purchases are relatively few today. Our research shows that only lifetime income annuities can protect individuals in an efficient way from the risk of outliving their assets and that this simply cannot be duplicated by mutual funds, certificates of deposit, or any number of homegrown solutions. We believe we’ve shown that income annuities clearly should be more widely used, given that highly rated insurance companies are reliable and inexpensive sources of guaranteed income streams in retirement.”

“With long-standing sources of guaranteed retirement income under stress, lifetime income annuities can play a pivotal role in helping consumers manage risk and establish the foundation for a secure and fulfilling retirement,” said Paul Pastiris, senior vice president of New York Life. “Today’s income annuity offerings are also designed to address many of the traditional consumer concerns discussed in the Wharton research, including access to cash when needed, inflation protection, and the ability to leave a legacy for one’s heirs, all while providing welcome peace of mind in retirement.”

Professor Babbel said, “Finally, markups have come down from 6-10 percent to less than half that today. Combined with the modernization of income annuities in recent years, insurers have eliminated most, if not all, of the reasons why consumers may have avoided these products in the past. With our academic findings now defining the enormous consumer benefits of income annuities, the arguments are compelling in favor of adding these products to retirement portfolios.”

Prof. David F. Babbel (Wharton) and Prof. Craig Merril (BYU, Wharton) have conducted extensive studies on the optimal level of annuitization under a wide array of financial circumstances.

Their findings emerge at a time when the decline in the number of Americans covered by defined benefit pension plans has alarmed economists in light of the confluence of economic and demographic changes underway. Prof. Babbel and Prof. Merrill found that it is optimal to annuitize a large portion of one’s wealth at retirement. As smaller portions are provided by corporate pension plans and Social Security, income annuities provide individuals with a guaranteed stream of monthly income for life in exchange for a lump sum payment to an insurance company. The professors found that the optimal portion one should annuitize depends upon the total accumulated wealth at retirement, the profit margins embedded in annuity pricing, age, risk tolerance, and the returns in the bond and stock market alternatives. They also found that, contrary to conventional wisdom, annuitization of a substantial portion of one’s wealth actually assists a retiree in providing a bequest for his/her heirs, and that the lack of annuitization renders one’s heirs, in effect, residual claimants with financial interest opposed to those of the retirees. According to the professors, the flexibility of modern annuities renders obsolete many of the criticisms that have been raised in the past.

Income annuities offer the advantage of risk pooling. The Wharton study found that because insurers can share the risk of outliving one’s savings across a large group of policyholders, income annuities can offer financial security throughout retirement using 25-40% less money than would be required to provide an equivalent