RESEARCH REPORTS. AMERICAN INSTITUTE for ECONOMIC RESEARCH. Protection Against Living Too Long. Published by. Great Barrington, Massachusetts 01230

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1 Published by AMERICAN INSTITUTE for ECONOMIC RESEARCH Great Barrington, Massachusetts 123 RESEARCH REPORTS Vol. LXVI No. 4 February 22, 1999 Protection Against Living Too Long Income annuities require you to give up control of your money, in return for the security of a steady income for the rest of your life. The size of the income depends on your age and on the insurance company; income rates vary substantially from one company to the next. One of the biggest financial fears of older people is that they will outlive their savings. Annuities provide protection against this risk, by allowing retirees to convert their savings into a steady stream of income that lasts for as long as they live. In addition to providing financial security, annuities are attractive to retirees who want to maximize their monthly income, perhaps to supplement their Social Security benefits or pay for ongoing uninsured medical expenses. Annuities are best suited to the circumstances of older people for two reasons: 1) older people are most likely to have accumulated sufficient funds to buy them, and 2) they are at an age at which the return on an annuity is most attractive. The income that can be obtained for a given premium increases with the age at which the annuity payments begin, because older individuals on average will live (and receive annuity income) for a shorter period than younger individuals. For example, if a 65-year-old man paid $1, for an annuity, he might receive an income of about $7 per month, based on the annuity income rates currently available. But if a 75-year-old bought the same policy, his monthly income would be about $99. An 8-year-old could buy an income of $1,2. Another advantage of annuities is that a large portion of the income usually is tax-free. This is because the income payments are partly a return of principal and partly a return on principal. If the annuitant was taxed on the principal (the premium) when he earned his income, a tax on the entire annuity payment would involve taxing that income again. Only the earnings on the premium payment constitute new income to the annuitant, and only the portion of annuity income that represents these investment earnings is taxable. The exception is an annuity purchased directly with funds from an IRA or other tax-favored retirement account. Assuming no tax was ever paid on either the original investment or the investment earnings in the IRA, all of the annuity income is taxable. IRS Publication 939 explains how to calculate the taxable portion of an annuity, but most insurance companies also indicate the amount on 199-R forms they send annually to annuitants. The annuity income that can be purchased with a given premium at a given age is usually greater for men than for women, because the life expectancy for men is shorter. Some insurance companies now use, by law or by choice, the same mortality tables for men and women, with no provision for taking into account the fact that women s actuarial life expectancies are longer. Women will find it to their advantage to buy from a company offering unisex rates. Men will find the opposite. Income Options A lifetime only annuity provides income until the annuitant dies, after which no further payment is made by the company. For this reason, the income from this type of annuity is higher than that from other types of annuities. This fact makes a lifetime-only annuity (also called a straight life annuity) advisable in far more circumstances than any other type. However, many people are reluctant to buy a lifetime-only annuity because they fear that they will die sooner than average and they will not get their money s worth. This is indeed a possibility. But if there are no others who need the income, its cutoff upon death is no loss to anyone. On the other hand, should annuitants live longer than average, they would receive in income much more than the original purchase amount, and they would have had the peace of mind that the income would not run out no matter how long they were to live. This is the very scenario that makes annuities an attractive option to begin with. Other income options include 1) an installment refund annuity, which provides that if the annuitant dies before the total income payments received equal or exceed the premium, the difference will be paid in installments to a named beneficiary, 2) a cash refund annuity, which pays any remaining premium to a beneficiary in a lump sum rather than a series of installments, 3) a term certain annuity, which guarantees that income payments will be made to the annuitant for as long as he lives, and further provides that if he dies within a specified period of 1, 15, or 2 years, his beneficiary will receive income payments for the remainder of that period. For example, if a retiree buys a lifetime annuity with 1 years certain payment, and he dies after receiving income for 3 years, income payments will continue to his beneficiary for 7 more years. The annual income from these and other income options is less than that from a lifetime-only annuity. This is because the company does not get to use all the unpaid balances of people who die earlier than average to make payments to those who die later than average. The Risk of Price Inflation Traditional annuities provide a fixeddollar income, which has one big drawback: in inflationary times, the purchasing power of the income is eaten away by rising prices. If price inflation remains relatively low, as it has been in recent years, this is a lesser concern. But there is no assurance that the rate of price increase will not accelerate. And even a relatively low rate of price inflation takes its toll over long periods. An annual inflation rate of just 3 percent would cut the buying power of the dollar to just 75 cents in 1 years. This makes fixed-dollar annuities a questionable investment for younger retirees, since they would be locked in to the fixed income for the longest time. So long as the price level continues to rise, the purchasing power of fixed-dollar annuity income is virtually guaranteed to fall. One alternative is a variable-rate annuity, which provides an income that varies with the return on the assets in which the principal is invested. The monthly in- 17

2 come is a fixed percentage of the value of the invested funds, but the dollar income will vary from one payment to the next. The income will fluctuate with the investment performance. Some policies provide a guaranteed minimum income, however this amount is likely to be smaller than the income from a comparable fixed-dollar annuity. In short, there is no risk-free or costless way to protect annuity income from the loss of purchasing power. Choosing a Policy It is essential to check the financial standing of any insurance company before buying an annuity. An annuity requires a large up-front investment in return for a promise of future income, and with a fixed-rate annuity that promise is only as good as the company that makes it. Moreover, once annuity income payments begin, it is difficult if not impossible to break an annuity contract and get a refund. There are five major ratings services that evaluate the financial condition of insurance companies: A.M. Best, Standard and Poor s, Duff and Phelps, Moody s, and Weiss Research. Insurance agents can provide the latest ratings at no charge, and some of the ratings services also provide them free at their websites. Comparing Income Payouts Annuity income rates vary greatly among insurance companies. The accompanying table shows the monthly income provided by an annuity with a $1, premium. The table is based on a survey conducted last June by the A.M. Best Company, one of the ratings services. A.M. Best rates insurance companies financial condition on a scale of A++ to F, and the table includes only companies rated A or higher. The income payments shown are for the life time only option, which provides the highest monthly payment until the annuitant s death and no payments thereafter. The companies are listed according to the highest income provided to 65-year old males. The relative rankings for the other categories of age and sex are similar but not identical. For example, SAFECO Life s annuity, which is based on unisex rates, pays $662 per month to a 65-yearold annuitant. This is the lowest of the Lifetime Only Annuity Income Rates Income payments cease upon annuitant s death Monthly Income per $1, Premium Age 65 Age 75 Company Rating* Male Female Male Female CUNA Mutual Life A $84 $771 $1,83 $959 American Family Life A , Mod. Woodmen of America A ,1 964 ReliaStar Life of New York A+ g ,5 92 Great American Life A g , Aid Assoc. for Lutherans A , Federated Life A , Equitable Life of Iowa A+ g ,57 96 American Heritage Life A ,6 9 Berkshire Life A , Kansas City Life A g ,42 99 Sunset Life of America A g ,42 99 COVA Fin. Services Life A ,5 916 Keyport Life A ,16 91 Aetna Life & Annuity A+ g u , Farm Family Life A ,37 98 Acacia National Life A ,65 93 Penn Insurance & Annuity A g ,3 874 Penn Mutual Life A g ,3 874 SunAmerica Life A+ g ,32 93 Lafayette Life A ,42 99 Amer. Gen. Life & Accident A ,31 91 Baltimore Life A g ,46 94 Security Mutual Life of N.Y. A ,34 9 Southern Farm Bureau Life A g , Fed. Kemper Life Assur. A ,22 89 Kemper Investors Life A ,22 89 TMG Life A++ g , 892 USAA Life A ,6 916 Northern Life A+ g , 893 Jackson National Life A ,2 875 AmerUs Life A g , 887 Delta Life & Annuity A , 887 Woodmen of the World A ,8 881 Variable Annuity Life A Manufacturers Life (USA) A++ g , Farm Bureau Life A , Union Central Life A Gleaner Life A Canada Life A++ g IDS Life A+ g Ameritas Life A+ g Lincoln Benefit Life A+ r Monthly Income per $1, Premium Age 65 Age 75 Company Rating* Male Female Male Female Lutheran Brotherhood A++ g $724 $65 $99 $863 Shenandoah Life A Midland National Life A Minnesota Mutual Life A American Life of N.Y. A+ g Great-West Life & Annuity A++ g Security Benefit Life A American Gen. Annuity A Standard Insurance A Franklin Life A+ g American General Life A+ g State Farm Life A American Mayflower Life A Equitable Life A g Old Line Life of America A Metropolitan Life A+ g Security First Life A g Indianapolis Life A g Sun Life of Canada (U.S.) A++ g American United Life A Provident Mutual Life A g Providentmutual Life & Ann. A g AUSA Life A Life Investors of America A Monumental Life A PFL Life A New York Life A++ g Northwestern Mutual Life A++ g American Life & Casualty A g American National A Manufacturers Life of N.Y. A++ g Manu. Life of N. America A++ g Massachusetts Mutual A Golden Rule Insurance A Mutual of America A+ g Lincoln National Life A+ g u Ohio National A+ g First SAFECO National Life A SAFECO Life A Highest Income $84 $771 $1,17 $982 Lowest Income Median Income Note: Companies are ranked by income rates for a 65-year-old male. The highest and lowest income rates for men and women of either age are underlined. Rates as of June * Ratings by A.M. Best in June 1998: A++ and A+ = Superior, A = Excellent, g and r = rating based on a company s affiliation with a group of insurers (g) or with a reinsurance company (r), u = under review for a rating change. Source: A.M. Best Co.

3 2 PRIMARY LEADING INDICATORS 1 M1 Money Supply (1) M2 Money Supply (1) Month Percent Change in Sensitive Materials Prices (6) [9/98] 2 1 New Orders for Consumer Goods (3) Contracts and Orders for Plant and Equipment (4) [1/98] New Housing Permits (3) (thousands)

4 .9 PRIMARY LEADING INDICATORS (Continued) Ratio of Manufacturing and Trade Sales to Inventories (3) [1/98].62 Vendor Performance: Slower Deliveries Diffusion Index (2) (percent) Index of Common Stock Prices (2) (constant purchasing power) Average Workweek in Manufacturing (3) (hours) Initial Claims for State Unemployment Insurance (3) (thousands, inverted) Month Percent Change in Consumer Debt (4) [1/98] Notes: 1) Shaded areas indicate recessions as dated by the National Bureau of Economic Research. 2) The number in parentheses next to the name of a series is an estimate of the minimum number of months over which cyclical movements of a series are greater than irregular fluctuations. That number is the span of each series moving average, or MCD (months for cyclical dominance), used to smooth out irregular fluctuations. The data plotted in the charts are those MCDs and not the base data. The number in brackets is the latest month for which the moving average is plotted. 3) The insets in selected charts show recent trends more clearly. These insets have arithmetic scales, even when the main chart is plotted on a ratio scale. 2

5 6 PRIMARY ROUGHLY COINCIDENT INDICATORS Nonagricultural Employment (1) (millions) [1/99] Index of Industrial Production (1) (1992 = 1) [1/99] Personal Income in Manufacturing (2) [1/98] 1,2 6 Manufacturing and Trade Sales (2) Civilian Employment as a Percentage of the Working-Age Population (2) Gross Domestic Product (1) (quarterly, constant dollars, billions)

6 6 PRIMARY LAGGING INDICATORS Average Duration of Unemployment (2) (weeks, inverted) 12 1,1 1,5 6 Manufacturing and Trade Inventories (1) 97 1, Commercial and Industrial Loans (1) Ratio of Consumer Debt to Personal Income (1) Percent Change from a Year Earlier in Manufacturing Labor Cost per Unit of Output (2) Composite of Short-Term Interest Rates (1) (percent) [1/99]

7 payouts available to men, but it is the median payout among women s policies. The highest and lowest income policies available to 65 and 75-year-old men and women are underlined in the table. Annuity income rates broadly track the general level of long-term interest rates in the economy. This is due to the fact that, by law and by custom, bonds account for the bulk of the assets that insurers use to back their annuity obligations. Not surprisingly, the income rates available today are lower than they were 1 years ago, reflecting the substantial decline in With five of our twelve primary leading indicators at new highs for the current cycle, the outlook for business conditions remains favorable. Four of those series, M2 money supply (M2 money supply, and all other dollar-denominated series are reported in constant dollars), new orders for consumer goods, new housing permits, and the ratio of manufacturing and trade sales to inventories, reached successive new highs. Barring any unexpected moves in the Consumer Price Index, the fifth series, the index of common stock prices, almost surely will attain another new high as well. (Owing to a late release of the CPI this month, there are no new data for that series.) All five series are appraised as clearly expanding. Disregarding its now-stale 1993 peak, M1 money supply also reached a new high exceeding its March 1998 interim peak. It now is appraised as clearly expanding, up from last month s probably expanding status. Thus, including M1, half of the leading indicators are at new highs. Contracts and orders for plant and equipment decreased for the third consecutive month off of its most-recent peak. The latest drop, however, was insufficient to warrant a change in its cyclical status. That series remains appraised as probably expanding. In contrast, consecutive decreases in the base data for initial claims for state unemployment insurance (inverted) warranted downgrading its cyclical appraisal from clearly to probably expanding. The 3-month change in consumer debt fell slightly to 1.88 percent, but remains appraised as probably expanding. Vendor performance, the percentage of purchasing managers reporting slower deliveries from their suppliers, warranted upgrading to probably contracting from last month s clearly contracting status. The average workweek in manufacturing fell to 41.6 hours per week, but remains appraised as probably contracting. BUSINESS-CYCLE CONDITIONS long-term interest rates. Ten years ago, a $1, policy purchased by a 65-year old man paid, on average, an income of $91 per month. Today, a comparable new policy pays only $742, nearly 2 percent less. Currently, interest rates are at a 2- year low. When the general level of interest rates eventually increases, the income payouts on new policies are likely to become more attractive. This is another reason, along with the better deals available to older people, to postpone buying an annuity as long as one s financial circumstances allow. The leading, coincident, and lagging indicators all suggest further expansion over the next several months. Of the twelve leading indicators, the 3-month percent change in sensitive materials prices currently is the only leading indicator with a clearly contracting trend. This series, now almost 4 years off its peak for the cycle, decreased another.12 percentage points this month. Overall, 75 percent (nine out of twelve) of the primary leading indicators are expanding, unchanged from last month. Similarly, AIER s cyclical score, our purely mathematical assessment of the leading Statistical Indicators of Business-Cycle Changes Change in Base Data Cyclical Status Oct. Nov. Dec. Jan. Primary Leading Indicators Dec. Jan. Feb M1 money supply? +? M2 money supply Change in sensitive materials prices? New orders for consumer goods r + Contracts and orders for plant and equipment +? +? +? Index of new housing permits Ratio of manufacturing and trade sales to inventories +? r - + Vendor performance -? - -? Index of common stock prices (constant purchasing power)? nc r nc r - Average workweek in manufacturing -? -? -? Initial claims for unemployment insurance (inverted) + + +? Change in consumer debt +? +? +? Percentage expanding cyclically Primary Roughly Coincident Indicators Nonagricultural employment nc Index of industrial production +? r + Personal income in manufacturing??? + + Manufacturing and trade sales Civilian employment to population ratio? Gross domestic product (quarterly) Percentage expanding cyclically Primary Lagging Indicators Average duration of unemployment (inverted) +? +? Manufacturing and trade inventories Commercial and industrial loans nc Ratio of consumer debt to personal income??? Change in labor cost per unit of output, manufacturing +??? Composite of short-term interest rates - -? - nc No change. r Revised. Percentage expanding cyclically Under Change in Base Data, plus and minus signs indicate increases and decreases from the previous month or quarter and blank spaces indicate data not yet available. Under Cyclical Status, plus and minus signs indicate expansions or contractions of each series as currently appraised; question marks indicate doubtful status when shown with another sign and indeterminate status when standing alone. 23 indicators is unchanged this month at 71. Both of these leading diffusion indexes remain well above the statistical threshold of 5 that indicates an impending contraction in economic activity is probable. Except for personal income in manufacturing, all of our roughly coincident indicators are at new highs for the current cycle. That series increased slightly, but not enough to reveal a cyclical trend. It remains indeterminate. Despite losses in the manufacturing sector, nonagricultural employment increased by 245, to a record 127,347, jobs. The index of industrial production is also at another new high. Manufacturing and trade sales continues on its established upward trend. According to the latest statistics for civilian employment as a percentage of the working-age population, 64.4 percent of the population is employed. The recently released advance estimate for gross domestic product (GDP) reported that the economy grew at a 5.6 percent annual rate in the fourth quarter of 1998 and at a 3.9 percent annual rate over the entire year. This performance reportedly astonished many forecasting professionals, who predicted a slowdown or contraction in GDP in the second half of Although our leaders suggested continued expansion throughout the year,

8 Percentage of AIER Leaders Expanding Cyclical Score of AIER Leaders PRICE OF GOLD Feb. 2 Feb. 19 Feb. 11 Feb. 17 Final fixing in London $345. $298. $287.3 $ Research Reports (ISSN ) (USPS ) is published twice a month at Great Barrington, Massachusetts 123 by American Institute for Economic Research, a nonprofit, scientific, educational, and charitable organization. Periodical postage paid at Great Barrington, Massachusetts 123. Sustaining memberships: $16 per quarter or $59 per year. POSTMASTER: Send address changes to Research Reports, American Institute for Economic Research, Great Barrington, Massachusetts we eschewed such quantitative predictions. As we often have stated, in our view the means for developing reliable quantitative forecasts of economic activity are simply not available and may never be. The models upon which such forecasts rely are notoriously inadequate to accommodate the complexities of real world transactions, especially when events depart, or are expected to depart, from their usual course. Overall, 1 percent (five out of five) of the primary roughly coincident indicators with apparent cyclical trends are expanding, unchanged from last month. Among the six primary lagging indicators both the average duration of unemployment (inverted) and manufacturing and trade inventories are at new highs for the current cycle. For the first time since August 1991, the average duration of unemployment is below 14 weeks. Both series now are appraised as clearly expanding. After reaching a new high last month, commercial and industrial loans fell this month, but remains appraised as clearly expanding. There are still no identifiable trends in either the ratio of consumer debt to personal income or the percent change from a year earlier in manufacturing labor cost per unit of output. The debt to income ratio held steady at percent and labor costs fell. Both series remain indeterminate. The composite of short-term interest rates fell to 4.81 percent in January, the first month since September 1994 that rates have dropped below 5 percent. This decrease warranted downgrading the series to clearly contracting. Overall, 75 percent (three out of four) of the primary lagging indicators with apparent cyclical trends are expanding unchanged from last month. Prior to a recession, the lagging indicators typically strengthen. With the interest rate, loan, and labor cost series at new lows; with strong inventories being offset by even stronger sales; and stable consumer debt, there is little in the lagging indicators to suggest the developing bottlenecks that could derail the current expansion. In short, the business outlook remains favorable. Chart 1 Selected Interest Rates 75 5 A False Signal Chart 1 plots the yield on 1-year Treasury bonds and the Federal Funds rate, the short-term rate banks charge each other to borrow money. Since June 1998, when the yield on 1-year Treasury Bonds fell below the Federal Funds rate, we have monitored these two series closely, since prior to the past five recessions long-term rates dropped below short-term rates. In June of last year it appeared that this behavior had recurred, and that interest-rate changes could be signaling a recession. However, this time the circumstances differed: i.e., the two series crossed not because shortterm rates had increased (as they are expected to do and had done prior to the previous five cyclical peaks), but because longterm rates decreased. Even in the cyclical episodes where the two series never actually crossed, short-term rates increased several months prior to recession. Short-term rates have instead been falling since last summer, and the leading indicators have remained relatively strong. This January, the latest month for which data are available, yields on 1- year Treasury bonds once again moved above the Federal Funds rate. Historically, these series have given relatively few such false signals. The two series crossed in the mid-sixties owing to an increase in the Federal Funds rate, and they failed to cross prior to the and recessions. Excepting those episodes, recession has ensued whenever the slope of the yield curve has turned negative. Continued observation of these series is, therefore, still warranted. For now, however, there is no end in sight to this record-breaking expansion. 1-Year Treasury Bonds Federal Funds Rate