Financial professionals often view guaranteed annuities as a sacrifice of potential portfolio growth for income stability in retirement, but a new analysis from retirement researchers David Blanchett and Michael Finke argues that this perspective misses a much more important point.
That is, data shows, annuities in real life act less as a defensive tool for those afraid of running out of money and more as a "license to spend." By shifting a portion of non-annuitized wealth into annuitized wealth, Finke and Blanchett find, the typical retiree could feel comfortable spending twice as much each year per dollar of accumulated savings.
"Economic theory provides both rational and behavioral explanations for under-spending among retirees with high non-annuitized wealth," Blanchett and Finke write. "Rational risk-averse retirees will spend less because they don't know how long they will live and face the risk of outliving savings."
Retirees may also exhibit behavioral preference that make them more comfortable spending from income than spending from assets, the pair note. These people get used to seeing their asset pool grow over a lifetime of saving, and the mental transition to decumulation — however well planned and controlled — is a big behavioral hurdle to clear.
Ultimately, both rational and behavioral factors may contribute to lower spending among retirees who must fund a lifestyle with less guaranteed income. This should inspire annuity-skeptical advisors and their clients to rethink the potential role of guarantees in the pursuit of their desired retirement lifestyle.
Consistent Findings Over Time
The new paper builds on a prior analysis published by Finke and Blanchett in 2021, when they first coined the "license to spend" terminology. The researchers have updated the math and raised some new considerations based on more recent developments in the annuity and income planning arena.
As before, Finke and Blanchett find that retirees in general don't spend nearly as much as they could from their investments, and subjective surveys of retirees suggest that many just don't like the idea of seeing their nest egg shrink — even if a reluctance to draw down investment assets leads to a reduction in lifestyle.
"We find strong evidence that households holding a greater share of their wealth in guaranteed income spend more each year than retirees who hold more of their wealth in investments," Finke and Blanchett write. "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."
By holding household wealth constant, the analysis shows that households are spending more not because they are wealthier — since financial assets can be converted to guaranteed income through actions such as delayed claiming of Social Security retirement benefits or purchasing an annuity. Rather, it is the form of the wealth they hold that affects spending in retirement.
Marginal estimates indicate that investment assets generate about half of the amount of additional spending as an equal amount of wealth held in guaranteed income, Finke and Blanchett find.
"In other words, retirees spend twice as much each year in retirement if they hold guaranteed income wealth instead of investment wealth," they write. "Therefore, every $1 of assets converted to guaranteed income could result in twice the equivalent spending compared to money left invested in a portfolio."
A Look at the Math
At the heart of the analysis is the fundamental tradeoff that unknown longevity presents. A retiree can either spend generously and risk outliving savings and experiencing a lifestyle disruption late in life — or can spend conservatively to minimize the risk of a shortfall. Retirees' individual risk tolerance determines their willingness to accept shortfall risk.
"A risk-averse retiree will prefer to avoid a possible drop in future spending, and will spend less to ensure the longevity of their nest egg," Finke and Blanchett write. "A risk tolerant retiree will accept the possibility of a shortfall and spend more in early retirement."
