Annuities have been around for centuries, in one form or another, but they don’t get much respect from the traditional investment industry, said Moshe Milevsky, associate professor of finance at York University’s Schulich School of Business. We interviewed him last summer as he was getting ready to launch his new monograph, Life Annuities: an Optimal Product for Retirement Income, published by CFA Institute. “They are usually associated with the fixed-income low-interest-rate environment. In an era when we are so fee conscious, some products with the name ‘annuities’ often charge fees in the hundreds of basis points,” he said. Also, “the irreversibility disturbs some people.”

Now that large corporations are transmuting defined benefit (DB) plans into defined contribution (DC) or getting rid of pension plans altogether, life annuities are starting to attract attention. “If you have a DC plan and you are close to retirement, you should consider buying an annuity,” said Milevsky, speaking from his office at the Individual Finance and Insurance Decisions Centre, a non-profit organization that researches wealth management, personal finance, and insurance. “A guaranteed source of income is a very important part of any retiree’s financial plan, and an annuity is one way to counteract longevity risk, especially by those baby boomers who have no DB pension and could very likely outlive their financial assets.”

“It’s not just longevity risk that should drive the decision,” Milevsky hastened to add. “What do you envision yourself doing at the age of 95? Will you be trading ETFs in your brokerage account? Or does your family have a history of Alzheimer’s and dementia?” If the latter, it may be sensible to “put the income on autopilot,” he said, and buy an annuity.

Behavioural finance has shown that “we can get horribly deceived by our intuitions and emotions,” he noted, and this is yet another reason to consider annuities for retirement.

CFA charterholders and investment professionals are just discovering annuities, said Milevsky, despite the fact that insurance companies and even governments have been selling them for the past three hundred years. There are two types of insurance that companies sell, he explained: “life and death, and annuities and human capital protection. One balances out the other, and both are an important part of the portfolio.” He also added that, as CFA Institute moves into wealth management, members must get to know these instruments and go beyond just focusing on generating, measuring, and selling alpha.

Halley’s payout

According to Milevsky, CFA Institute is looking at including annuities in the Candidate Body of Knowledge (CBOK), and that spurred them to suggest his monograph on the subject. His 2007 monograph, Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance, co-authored with Roger Ibbotson, Peng Chen and Kevin Zhu, has since been adopted into the CBOK.

A significant contribution of Milevsky’s monograph is the literature review and categorization of over one hundred scholarly articles on the subject. “The most difficult task was finding the common denominator,” he said, but he has managed to divide them into six categories of topics, including pricing and hedging, and timing and allocation.

There is a pronounced historical aspect to a review of annuities. “When King William of Orange needed to fund his war against France, he borrowed money with annuities,” Milevsky explained, marvelling that “they did not charge based on age.” In 1693, astronomer Edmond Halley showed that annuity payouts should be age-based, but it was not until 1790, during the reign of King George III, that annuities began to be priced that way. It is “interesting how long the science was ignored before it was taken into account in the pricing,” Milevsky noted.

Milevsky is so intrigued by the history of finance that he is currently working on his next book which is tentatively titled, Who Murdered the Tontine? (forthcoming publication by Cambridge University Press). In it, he explores in detail an ancient type of annuity in detail, including “the dealings and the fraud.” No longer part of the curriculum or landscape of actuarial science, the tontine is a financial arrangement whereby the participants contribute equally to a prize that is awarded entirely to the participant who outlives all the others.

If life annuities make it to the CFA curriculum, “mortality credit” or “longevity bonus” is a term that candidates will become familiar with. Milevsky explains it thus: “If we put money into a pool, and only survivors get to share the money [after a certain time has elapsed], we need a term to refer to the extra money the survivors get because of the people who died.”

Annuities Instead of Bonds

Milevsky agrees that nowadays consumers who consider annuities have “legitimate concerns” about credit risk, illiquidity, and low interest rates. He said credit risk can be mitigated by buying the product only from AA – or AAA -rated financial institutions, and the consumer should buy multiple annuities from different providers, up to the Assuris-mandated limit. Assuris is a body like the Canada Deposit Insurance Corporation (CDIC) that guarantees payouts to a certain limit in the event of a company’s failure. To mitigate the interest rate risk, the consumer should buy annuities at different times. Milevsky contrasts long-term strategies (“you need annuity-type income”) with short-term tactics (“don’t lock into one at low interest rates”). Also, he suggests annuities as a replacement for the bond component of a retirement portfolio. “If you own bonds—incurring the risk of rising rates— then you might as well switch them into annuities,” he added.

Since these products are illiquid, no more than 30 to 40 percent of a portfolio should be annuities. “You need to have enough for emergencies,” he warned. If a consumer is over-annuitized, then the monthly payments should go toward buying long-term care insurance or health insurance so that funds are available when needed. One can even use the monthly payments to purchase life insurance and create a legacy.

Annuities of the future might not be paid out in cash, suggests Milevsky. They might be paid out in services such as utility bills or pharmaceutical products, especially in countries where the currency might be unstable, which would avoid basis risk. Service-based annuities hearken back to the middle ages. “In olden times, the rich elderly would move into the monastery, where the monks would take care of them. That was their form of annuity, called a ‘corrody,’” he explained. “As baby boomers get into retirement, they will look at innovative ways of filling their needs.”

In a clever historical study, Salm (2011) used changes in pension laws for U.S. Union army veterans as a natural experiment to estimate the causal effect of pensions and life annuities on longevity. Examining the effects of the pension laws of 1907 and 1912, which granted old-age pensions to Union army veterans, he found that veteran pensions reduced mortality for both acute and non-acute causes of death. So, the endogeneity of income and longevity-contingent claims is not as farfetched as you might initially suspect. All of these findings echo the famous Jane Austen quote from Sense and Sensibility (published in 1811): “If you observe, people always live forever when there is an annuity to be paid them.”

The English poet and author Geoffrey Chaucer (1343–1400), at the young age of 35, so enthralled King Edward III that the king granted him a unique annuity—one gallon of wine daily for the rest of his life, to be served in the port of London. (That would be 16 glasses of wine per day, which gives me new respect for the fact that The Canterbury Tales got written at all.)