Why Annuities Work Like a 'License to Spend' in Retirement

Workers in the defined contribution era generally retire with a lump sum of assets. As fewer workers retire with a pension, the percentage of retirement income funded through guaranteed income is likely to continue declining as well.

The implications of this change on retirees is unclear. There is evidence from previous studies that many spend far less in retirement than they could comfortably withdraw from savings.

Deciding how much to spend each year in retirement from investments is complicated when both the length of retirement and asset returns are unknown.

Unknown longevity presents a tradeoff in which a retiree can either spend generously and risk outliving savings, or spend conservatively and live a less enjoyable retirement. A retiree who prefers not to accept the risk of outliving savings will spend less.

An alternative to spending from investments is to transfer the risk of an unknown lifespan to an institution, such as a pension, the federal government or an insurance company. A rational, risk-averse retiree who does not transfer longevity risk will spend less each year than if they had purchased a fairly priced income annuity.

Failing to Annuitize

Economic theory predicts that a retiree with similar annuitized wealth will spend more than a retiree with an equal amount of non-annuitized savings. The lifestyle that retirees give up by failing to annuitize is referred to by economists as the annuity puzzle.

Retirees may also experience behavioral costs from failing to annuitize. Retirees who are behaviorally resistant to spending down savings may better achieve their lifestyle goals by increasing the share of wealth allocated to annuitized income.

This could take the form of delaying claiming Social Security retirement benefits, choosing a job with an employer pension or purchasing an income annuity.

An annuity can not only reduce the risk of an unknown lifespan, it can also allow retirees to spend their savings without the discomfort generated by seeing one's nest egg get smaller.

'A License to Spend'

Annuities may also 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.

This is surprising since funding a lifestyle is presumably what motivates retirement saving to begin with, and few retirees indicate a desire to pass on significant wealth at death.

In a new research paper, we analyze how the composition of wealth is related to spending in retirement using data from the Health and Retirement Study (HRS).

We do this by looking at households with at least $100,000 in savings and compare how much money the households could be spending in retirement, based on existing guaranteed income sources and assuming financial assets are annuitized, versus how much they actually are spending.

We find strong evidence that households who hold 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.

By holding household wealth constant, the analyses show that households are spending more not because they are wealthier (since financial assets can be converted to guaranteed income); rather it's the form of the wealth they hold that impacts spending in retirement.

Marginal estimates suggest that investment assets generate about half of the amount of additional spending as an equal amount of wealth held in guaranteed income. In other words, retirees will spend twice as much each year in retirement if they shift investment assets into guaranteed income wealth.

In other words, every $1 of assets converted to guaranteed income will result in twice the equivalent spending compared to money left invested in a portfolio. The size of the effect is large enough that the explanation is likely a combination of behavioral and rational factors.

These findings have important implications for financial advisors and retirees.

While studies on optimal annuitization have generally focused on the economic benefits, shifting assets from savings to lifetime income can provide a retiree with the psychological benefit of being given "license to spend" accumulated savings.

The ability to gain greater enjoyment from savings is an important reason to consider funding guaranteed income from investments either through delayed Social Security claiming or by annuitizing a portion of retiree savings.

David Blanchett is managing director and head of retirement research at QMA, the quantitative equity and multi-asset solutions specialist of PGIM, the $1.5 trillion global investment management business of Prudential Financial.

Michael Finke, Ph.D., is a professor and Frank M. Engle Chair of Economic Security at the American College of Financial Services, where he leads the Wealth Management Certified Professional program.