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Annuities as an Asset Class for Fee-Based Advisors l 21 © Envestnet 2022 Money's Worth Measures for Income Annuities Annuities have a reputation for being a high-fee financial product. Is this reputation deserved? We will address this for different types of annuities, starting first with income annuities. It is a bit complicated to answer this for income annuities because they do not have visible fees. There are no fees extracted from the quoted payout rate, as the payout rate is already a net number after fees have been deducted internally. Simply, with the internal fees, the quoted payout rate is lower than otherwise possible. Fortunately, we can reverse engineer the fair price for an income annuity without fees and then compare it with real-world annuity payout rates to obtain a money's worth measure for the income annuity. The "fair price" without overhead costs just involves using interest rates and mortality rates to calculate the survival-weighted present value of the potential lifetime payments. The additional complication relates to making reasonable assumptions for interest rates and mortality rates. In determining the money's worth for an annuity, we must consider three issues: could the retiree earn the same returns from her own fixed-income investments with the same risk level, how does the retiree's objectively determined longevity prospects compare with that of the overall risk pool, and how much does the retiree value mortality credits as based on her longevity risk aversion and subjective views about how long she might live. Purchasing income annuities can be a win-win situation both for the consumer and the insurance company when the benefits created through risk pooling are shared between both parties in the transaction. 1 First, can a retiree invest in the same fixed-income portfolio and earn the same returns as the insurance company can obtain for its general account? We note that the insurance company may be able to obtain higher investment yields because of its ability to diversify among higher-yielding bonds with greater credit risk, to use asset-liability matching to hold less liquid and longer-term bonds, and to receive institutional pricing on purchases which avoids the pricing mark-ups faced by retail investors. Second, it is important to be realistic about longevity when determining whether an income annuity is priced fairly. Someone who can reasonably expect to live longer than average should not try to calculate a fair price using population- average mortality. If annuity prices are simulated with mortality rates for the general population, that will cause the money's worth measures to be lower and annuities to look more expensive. My readers will tend to display characteristics that are associated with increased longevity, such as higher education levels, more income, greater wealth, and a stronger health focus. When this is the case, money's worth estimates based on mortality tables reflecting the longer lifespans of annuitants are more reasonable to use. Third, separate from the objective money's worth measure, it is important to also consider the subjective value being received by the annuity owner. For those with longevity risk aversion, the prospects of spending from investments may be such that an income annuity could still support more spending than the retiree otherwise would be comfortable taking from investments. With an investments-only strategy, longevity risk aversion is manifested through a lower spending rate from investment assets. Because income annuities pool longevity risk, they can help to reduce the worry individuals have about outliving their assets. 2 3

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