The Value of Allocating to Annuities

Abstract

This article explores the costs and benefits associated with different approaches a financial advisor could take toward using (or not using) annuities across his or her entire book of clients (i.e., for an entire cohort of retirees). Fees are used to proxy the implied total expenses (or costs) for the two approaches, and not surprisingly, the relative fees between the portfolio and the annuity has a significant impact on the respective benefit of each. For example, a financial advisor would be better off not recommending annuities at all (on average), if the investment-only approach is considered to be low cost and the annuity approach is assumed to be high cost. If the fees for both approaches are assumed to be moderate (i.e., the implied total expenses of the strategies are equal), which is the most realistic scenario for financial advisors providing high-quality advice to clients, the average annuity allocation across scenarios is approximately 30% and helping retirees allocate to annuities optimally generates a total of 73 basis points of alpha-equivalent benefit compared with a financial advisor that does not consider annuities as part of the retirement plan. The marginal alpha-equivalent benefit associated with optimal annuitization strategies, which is estimated by focusing on the total additional benefit generated from allocating to annuities based on the percentage of assets actually used to purchase the annuity, is closer to 150 basis points—a level of increased risk-adjusted performance that would be almost impossible for a financial advisor to overcome using traditional investments (i.e., ignoring annuities).

TOPICS: Wealth management, retirement

Key Findings

• • Annuities can help retirees generate guaranteed income for life, something that is impossible for investment-only product.

• • The potential value of annuities, relative to investment-focused approaches, depends significantly on the assumed costs of the respective strategies.

• • Not considering annuities for retirees because some annuities are expensive can result in inefficient and imprudent retirement plans.