Unlocking Hidden Returns: How Mortality Credits Boost Retirement Income
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today is episode 512. It's titled, Unlocking Hidden Returns, How Mortality Credits Boost Retirement Income. For the past six months, I've been part of a working group that is seeking to pull together some best practices for financial planners and advisors.

This group is made up of some very smart advisors, very well known. Now, I'm not a financial planner. My expertise is in investing, so I'm not sure how I got invited, but I have found it incredibly interesting.

I certainly have given a lot of thought to financial planning and advisory practice, especially when it comes to annuities. We've done over a dozen free and premium plus episodes on different types of annuities.

Up until the great financial crisis, I knew very little about annuities. We were managing assets for financial advisors, and I met with some of their clients and saw how shell-shocked they were.

having lost a lot of money in the downturn where the stock market fell close to 60%. And that sent me looking for other solutions that could help retirees that didn't want to be exposed to market risk, or at least to the extent that they had been. And that is where I learned about annuities. Went to some conferences, did a lot of study on it. And so on a recent call, one of these advisors made a comment

about immediate annuities and annuities in general that really surprised me.

An immediate annuity is a type of insurance product in which the insurance company accepts a one-time premium from the annuitant. Could be $100,000 and then the insurance company agrees to pay that annuitant and in some cases, the annuitant's spouse for the remainder of their lives. These income annuities are a form of longevity insurance because you get guaranteed income for life. Now,

Now, often when an annuitant purchases an immediate annuity, there is a guaranteed period of time in which their beneficiaries will continue to get the payment, the monthly payment, even if the annuitants pass away. It could be 10 years. And partly it's because in the initial years of the annuity, much of those payments are being funded by the principal, the premium that was paid. And

Having that period guarantee can be quite comforting because otherwise, if the annuitant dies in the first year or two after making the payment, then they're out of luck. That money is gone and not available for their heirs. Now, back to this working group. This financial advisor said he would never buy an immediate annuity.

Now, that didn't surprise me. A lot of financial advisors wouldn't buy an immediate annuity, partly because maybe they don't understand them, but they also know that they're paid an asset management fee. Their income depends on the size of the portfolio that they're managing. And if a

big chunk of that portfolio goes to an insurance company, then the advisor is making less money now. And in working with this advisory client I had back in 2008, that was one of the issues when we started talking about annuities, how will the advisor get paid since they didn't sell insurance products?

I recently saw a social media ad for Fisher Investments, and the headline was, Beware of Annuities. And their lead was to try to discourage the use of annuities. But insurance products are tools. They can be incredibly helpful if we understand them. But every insurance product isn't suitable for a given individual.

There are many very high net worth individuals where an immediate annuity is guaranteed income for life doesn't make any sense, not useful because they already have enough income, even if they invest very conservatively. But that's not what this advisor was talking about. He wasn't necessarily against annuities. He said he would never buy an immediate annuity, only a deferred income annuity.

Now, first, let's look at what a deferred income annuity is. It's like an immediate income annuity in that the annuitants pay a premium today, but instead of getting the income immediately in monthly payments for the rest of their lives, that first payment is delayed. It could be delayed 10 years, 15 years. The annuitants is 65, the retiree, maybe they don't want that first payment until age 80.

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Here's why that advisor preferred deferred income annuities over immediate annuities. He said that mortality credits don't cover the costs embedded in the annuity, the immediate annuity, until the annuitant is in their late 70s or 80s. In other words, he said deferred income annuities have higher mortality credits, which are

are desirable and there are more of them with a deferred income annuity than there is with an immediate annuity. What in the world are mortality credits? Here's a definition by Wade Pfau in his book, Safety First Retirement. He writes, those who fall short of

of life expectancy. These would be annuitants that buy an immediate annuity. So those that die in the first couple years of their annuity, they subsidize the income for those who live a long time. Those subsidies are known as mortality credits. He writes, while receipt of these subsidies clearly benefits the long-lived, arguably both groups can benefit by enjoying higher spending while alive because they have pooled the

the longevity risk. Their spending can be based on averages, and they do not have to self-manage the risk by planning for an overly long retirement.

An individual investor can self-manage their longevity risk. They retire at age 65. They assume they're going to live to be 95, 30-year retirement. They could go out, set up a bond ladder, buy individual bonds that mature each year for the next 30 years, and they could manage that risk. But due to mortality credits that come with annuities, the amount of

of money that a retiree needs to fund a bond ladder and get that payment stream for life is much higher than they would if they bought an immediate annuity because of mortality credits. Some annuitants will die early and their premium payment helps fund annuity payments for those that live into their 90s.

Here's how ChatGPT describes mortality credits. Mortality credits are the unique return component of annuities that arise because some annuitants pass away early.

leaving their unclaimed benefits to those who live longer. These credits effectively boost the return for survivors. I like the idea of thinking of mortality credits as a return booster. It increases the income by using an immediate annuity.

Now, that financial advisor says he prefers deferred income annuities because the mortality credits are higher than with an immediate annuity. More of the return comes from subsidies versus the underlying returns generated by the insurance company. Insurance company is investing those premiums. Much of the investment is in bonds. And so some of the return, the payment, the promised payment for annuities

annuities are tied to what interest rates are. What can the insurance company earn on their investments? And insurance companies are generally conservative investors. But with these deferred annuities, then there's more of this subsidy, these mortality credits.

I found a post on Boglehead by the author that goes by the pseudonym Go With The Cash Flow. And he described an annuity, an immediate annuity, a deferred annuity, like a series of zero coupon bonds. We introduced zero coupon bonds in episode 464. It's a government bond that doesn't have a coupon payment, doesn't make an interest.

interest payment, it's not generating that cash flow. A five-year zero coupon bond, you buy the bond and then five years later, you get the principal and interest payment. In other words, you buy the bond at a discount and then you get the full amount, including the imputed interest

interest rate when the bond matures. And this author on Boglehead is saying an annuity, be it an immediate annuity or a deferred income annuity, are like a series of zero-coupon bonds where there's a payment each year, or it could be monthly, and an insurance company could essentially fund that with a series of zero-coupon bonds that mature in the

the year or month that the payment is due. It's an asset liability matching approach. Now, as an individual, that's essentially what a bond ladder is, except it's

it could be done with zero-coupon bonds. Sometimes it's done with treasury inflation protection securities or even nominal treasuries, in which case there's cash flow coming in, but it could be done with these zero-coupon bonds. So this author writes, a 20-year zero-coupon bond, when held to maturity and assuming no default risk, guarantees a specific payment

in 20 years. Similarly, a 20-year zero-coupon deferred income annuity guarantees a specific payment in 20 years contingent on the annuitant's survival. Since the payment is contingent on the survival of the annuitant, a fairly priced zero-coupon annuity will be cheaper than a zero-coupon bond of the same maturity and therefore will have a higher return.

In other words, because there's the potential for the annuitant to pass away and then the proceeds of the zero-coupon bond could go to a different annuitant, the zero-coupon annuity would be cheaper than a zero-coupon bond where the payment definitely was going to be made. The author continues, the difference in the returns of the zero-coupon bond and the zero-coupon annuity is often referred to as a mortality credit. It's the additional return because...

because of the subsidies embedded into both income annuities and deferred

income annuities, with deferred income annuities benefiting from even more mortality credits because the first payment's not coming for 10 to 15 years, and that gives time for the annuitants to pass away. Whereas with an immediate annuity, the vast majority of annuitants aren't going to pass away in the first five years of the annuity, and so most of those cash flow payments are being funded from the

the premiums, but also the earnings on the investments, there's not much subsidy because very few annuitants have died in the pool. So until more annuitants die, returns are going to be more bond-like yield. Before we continue, let me pause and share some words from this week's sponsors.

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I wanted to go through an example of the mortality credits, but some numbers around. I went to immediateannuities.com. This is a website that has pricing, current pricing for annuities. I wanted to simplify it as much as possible. So I just assumed a 65-year-old, single male, $100,000 that they want to place in an annuity that

The choice is between an immediate annuity or a deferred income annuity. A 65-year-old male has a life expectancy of 17 years based on Social Security actuarial tables. So would die around 81 or 82. Based on current pricing today, that annuitant, that 65-year-old could survive.

start receiving this year $7,776 per year for the rest of their life.

Now, insurance companies base the pricing of annuities that the amount of that payout is based on life expectancies. So the median person in that pool will live, male will live 17 years. And so if we assume that they live 17 years and received $7,800 a year for 17 years and invested $100,000 in the premium, what would the rate of return be?

What is that internal rate of return to where you're essentially cashflow neutral? You get $700, $800 a year for 17 years for your $100,000. And that equates to a 3.8% annualized return. That's the internal rate of return of that cashflow stream. Alternatively, that same annuitant decides I'm going to buy a deferred income annuity. I'm 65. I have my $100,000. I will take the first payment when I turn 80. The

The life expectancy of an 80-year-old is eight years. So at the beginning of the 80th year, this annuitant that purchased the deferred income annuity gets their first payment. It's a whopping $29,496, much higher than they would have gotten had they just got the immediate annuity because they're not getting payment for 15 years. And then let's say they live their expected life another eight years. They get eight.

get eight payments of $29,496. So they get well over $200,000 for their $100,000 premium.

Meanwhile, the insurance company is investing it all along. And again, we can look at that payment stream, the $100,000 payment at age 65, at age 80, getting $29,496 for eight years. What's the internal rate of return? It's 4.8% annualized.

It's a percentage point higher than what the immediate annuity pays out. Now, under both scenarios, it's based on prevailing interest rates, what insurance companies can earn. They look at the current yields on treasuries, on corporate bonds. They price bonds. Bond yields aren't

A percent higher when you're going out 15 years, the yield curve is pretty flat right now with longer term treasuries yielding around four and a half percent, not that much different than five year treasuries or two year treasuries. So it isn't the shape of the yield curve that's leading to a higher internal rate of return for the deferred income annuity. It's the mortality credits.

During that 15 years, annuitants are passing away. So some of that $29,496 annual payment is coming from annuitants that bought deferred income annuities and didn't make it until that first payment. And because of that, the mortality credits are higher. The rate of return, the internal rate of return of that payment stream is higher than with an immediate annuity.

Now, there's another way to kind of look at this, a little more complicated. What if the retiree decides, I want nothing to do with annuities? I'm going to construct a bond ladder made out of treasury inflation protection securities, a 17-year ladder. So they're going to assume that...

They live 17 years. They have $100,000 they're going to put into this bond ladder and their annual payment. And I use tipsladder.com to construct this again, based on today's interest rates, the annual real payment before adjusting for inflation would be $6,900 per year. That compares to that immediate annuity, which is again, based on an expected life of 17 years, paid out $7,800 per year. So

The immediate annuity is paying $900 or more, but you get the inflation protection with the bond ladder, the TIPS bond ladder. You do not get inflation protection with the immediate annuity. And that's one of the downsides to that product.

Now, my question was, what's the break-even inflation rate? You're starting out with a lower payment with the bond ladder than you get with the immediate annuity, a $900 difference. What does the inflation rate have to be? Because with the tips, the principle is being adjusted and you're getting inflation-adjusted payments. The real payment stays the same at $6,900 a year. That's locked in, but whatever the inflation component, turns out the break-even inflation rate's 1.5%. So if...

Inflation is 1.5% or higher over the next 17 years. The bond ladder was a better deal if the retiree dies in the 17th year. But the benefit of the immediate annuity is the guaranteed income for life if they live longer than their average.

their actuarial expected life because of the mortality credits. And we can see the impact of mortality credits by calculating another break-even inflation rate. I went to tipsladder.com and let's assume this time the 65-year-old thinks they're going to live 23 years to 87, the same age that the deferred income annuitant example we gave lives to. That individual took out the deferred

Income annuity started paying out at age 80, and then it went for eight years. In this case, $100,000 bond ladder, the payment is $5,500 before inflation.

So now it's around $2,300 less than the $7,800 immediate annuity payment. Both are going to go for 23 years because the immediate annuity goes until the annuitant dies. And so for 23 years, the immediate annuity, $7,800 a year for 23 years. The bond ladder, inflation adjusted payments for 23 years. What's the break-even inflation rate where the retiree would have been better off with the bond ladder? In this case, it's 3%. So 1.5%

higher than with the 17-year bond ladder. That difference in the break-even inflation rate is another way to measure the mortality credit. Inflation would have to be higher than 3% per year for the bond ladder to have been the better deal. Again, assuming the retiree dies when they're 87. If they live longer, then the immediate annuity is a better deal.

So the fact that the break-even inflation rate is higher, the longer your bond ladder, that reflects mortality credits because we're comparing the bond ladder to an immediate annuity. There's a pulling impact to this.

So what's our takeaway? I've helped family members and friends, actually, I guess I've only helped family members, extended family members purchase immediate annuities in the past. We've walked through examples. And by and large, these were individuals that wanted steady income now. They wanted peace of mind to be able to cover fixed expenses. They could purchase the immediate annuity and the remainder of the assets were there to fund the

inflation adjustments because the immediate annuity is the same for the rest of their life as in the 10th year you need more money to cover higher costs due to inflation. But not all the assets were placed in an immediate annuity, just a portion of them. And it's worked out and they've

been at peace. Now, generally speaking, these were not wealthy individuals. And as a result, this was hugely impactful to their quality of life. An immediate annuity in that case makes sense. On the other hand, when I retire and many others,

A deferred income annuity could make some sense because I can maximize the mortality credits. I don't need the peace of mind necessarily of an immediate annuity. I need the peace of mind of longevity insurance. I can manage my assets in the early years of retirement.

but I want protection if I live well into my 80s. And since the early years of an immediate annuity, those payments basically track the bond market, the pooling benefit, the mortality credits don't really kick in until you're in your 70s or 80s, then a deferred income annuity could make a lot more sense for Lepril and I. Now,

Now, granted that with the deferred income annuity, you're subject to more inflation risk because you're not getting payments today. But look at the difference in those two annuities. The deferred income annuity purchased by a 65-year-old male today takes payment at age 18.

80 for 15 years, $29,456 compared to $7,776 for the immediate annuity in the first year. For $7,776 to grow to $29,456 in 15 years, that's a 9.2% annualized return.

Part of that's the deferred payment, the mortality credits. But my point is that $29,456 that kicks in in 15 years can be hugely impactful for that retiree to cover them for the next eight to potentially 15, 20 years, even with inflation. So

So deferred income annuities is certainly something that I'm going to consider. I'll also consider an immediate annuity. I'll do a comparison. What we can do is we can look at the pricing. We always have the optionality to delay buying either type of annuity, but this is another tool that potentially we can use to maximize the mortality credit, that additional return due to insurance annuities.

So we have to do the math. We have to see what our asset level is. What's our expenses? Do we need the peace of mind from an immediate annuity or can we manage our portfolio in the early years of retirement and buy the longevity risk with the deferred income annuity?

Wade Pfau in his book points out the Safety First Retirement book, the idea that sometimes individuals don't want to buy deferred income annuities or immediate annuities when interest rates are low. But he points out and writes, with low interest rates, the mortality credit component of the annuity payout becomes even more important, making annuities even more attractive relative to bonds.

The bond interest component for spending is reduced for both tools as interest rates decrease.

Construct a bond ladder three years ago looks very different than constructing a bond ladder today. And with lower interest rates, the mortality credit is even more important. Fowle continues, the bond interest component for spending is reduced for both tools as interest rates decrease, but annuities are hurt less by lowering interest rates since the mortality credit component for spending is not impacted by interest rates. It

It's completely separate. One of the principles we've taught over the past decade on money for the rest of us is diversification. Mortality credits are a diversifier because it's not dependent on interest rates, dependent on life expectancies, which could lengthen, could shorten, but it's a different return driver.

And the idea of thinking of mortality credits as incremental return to boost our income, to me, it makes it more intuitive. I can understand that. I can grasp that because, frankly, mortality credits has always been a little fuzzy for me. So this episode has been helpful for me to kind of walk through the analysis. I've been aware of deferred income annuities. I haven't done an episode on them. I was aware of them back in 2008, and I thought,

That could make some sense, but I was so new to annuities, I just focused on immediate annuities. But deferred income annuities do benefit more from mortality credits because those first payments are deferred for 5, 10, or 15 years. So that's our discussion on annuities. Again, not for everyone, but they can be an effective tool for some retirees. That's episode 512. Thanks for listening.

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