Understanding Mortality Credits in Annuities for Retirement Income

What Are Mortality Credits?

Mortality credits in an annuity are often referred to as an additional return on your investment, on top of the interest credited to the contract. This characterization is reasonable, but there are some important caveats to consider:

• Only payout annuities (immediate or deferred income annuities) benefit from mortality credits. Annuities used as tax-deferred accumulation accounts do not.

• Including a return of premium death benefit reduces the value of the mortality credits.

• Mortality credits are much higher at older ages, which should be considered when deciding at what age to buy an annuity.

• Mortality credits can be seen as mortality debits for those who die earlier than the average life expectancy.

  
  

The Role of Annuities in Retirement Planning

Annuities issued by an insurance company are currently the only way to purchase a stream of income that is guaranteed to last exactly as long as you live. These products are a valuable tool for addressing the dilemma of ensuring that 401(k), IRA, and other retirement savings produce income for the uncertain duration of your life after retirement.

However, using your entire retirement savings to buy an immediate annuity the day you retire is unlikely to be the optimal solution for providing a secure and well-funded retirement.

Considerations for Immediate Annuities

• The vast majority of immediate annuities purchased are fixed annuities. This means the implied investment return on your account is based on currently available bond yields. Given the expected length of most retirements, completely removing equity market exposure will likely reduce the amount of money available to spend in retirement.

• Immediate annuities are very poor liquidity vehicles. This means it may be costly or difficult to access funds above the prescribed payments if needed.

• The main benefit of a payout annuity is the longevity insurance protection. The cost of buying this protection increases slowly until you reach your 70s. This suggests that keeping the money in more diversified investments until then might produce better outcomes.

  
  

The Math Behind Mortality Credits

While it is true that mortality credits can improve the overall return on your investment in an annuity, the impact can be negative or positive, depending on how long you live. The concept is simple: a group of people, say 1,000, purchase an annuity for $100,000 each. In return, they receive a payment each year for the rest of their lives.

The amount of the annual payment is determined by the marketplace of insurance companies. It represents the insurance company’s estimate of how many people from the original 1,000 will be alive each year in the future, how much they will make investing the money while they have it, along with their estimated expenses for administering the contracts and the profit they expect to make for their shareholders (or policyholders for a mutual company).

Understanding the Transaction

So how does this transaction result in a return on investment for the buyer of the annuity? This is an unusual transaction where the buyer is willing to accept negative returns if they die significantly earlier than the average for the group. In exchange, they receive enhanced returns if they live much longer than the average person in the group.

The reason for making this unusual bet with a portion of retirement assets is rational. The payoff on the investment matches their need. They need income if they are still alive and don’t need it after they die. It is crucial that the money used to purchase the annuity is intended for spending during retirement, rather than being left to beneficiaries or given to charities. Money for these other purposes should be identified and separated from retirement income assets.

Example of Annuity Payments

Continuing the example, the payments and returns would look as follows:

• Purchase Cost of Annuity: $100,000 (Bought at Age 70)

• Annual Income While Alive: $9,500

• Implied Return on Purchase Price:

- Death Occurs at Age 75: -18%

- Death Occurs at Age 85: 6%

- Death Occurs at Age 95: 9%

It seems clear that these types of annuities shouldn’t be purchased for their high return potential. The main benefit of the annuity is the matching of income with the need for income. However, you can see the impact that mortality credits have on returns as you live longer.

The death at age 85 scenario is close to the average life expectancy and represents the returns associated with the interest earned by the insurance company from investing the money in bonds. The negative returns from early deaths fund the higher returns achieved by those who live beyond the average life expectancy.

How to Best Use Annuities

Annuities are best used as a component of a retirement portfolio. They balance the need for insuring income beyond an average life expectancy with the benefits of higher expected returns available in other investment vehicles, such as low-cost ETFs.

Mortality credits are more powerful at higher ages. This suggests that it is best to begin allocating out of other investments into an annuity around age 65. A portfolio of ETFs that incorporates a dynamic withdrawal strategy based on life expectancy and projected future investment returns, along with an appropriate allocation to life-contingent annuities, can be a very effective approach to optimizing retirement income.

Conclusion

In summary, understanding mortality credits is crucial for making informed decisions about annuities. They can enhance your retirement income, but it's essential to consider your unique situation and needs. By integrating annuities into a well-rounded retirement strategy, you can help secure your financial future. Remember, the goal is to maximize your retirement income while ensuring that your needs are met throughout your retirement years.

For more information on how to effectively use annuities, check out How to Best to Use Annuities.