During the accumulation years, participants in defined contribution retirement plans need to be sure that they are making adequate contributions to their plan and that these contributions are appropriately allocated among various asset classes. Upon retirement, participants have to decide how to generate income from their account balances. One of the most important questions is whether or not to purchase a life annuity, for all or a portion of one’s retirement income. As a life annuity guarantees payment of income as long as the participant lives, it can provide significant peace of mind. As this paper will demonstrate, the life annuity also provides the maximum amount of living income. However, there are many retirees who are hesitant to purchase life annuities for a number of reasons, including: the loss of control of retirement assets: the loss of liquidity and flexibility; and the potential for early death (and consequently early loss of principal.) During the past few years there has been yet another reason for not purchasing a fixed life annuity: the belief that interest rates are currently low and that one can achieve better results by waiting to purchase the annuity when rates will be higher. (Whether rates will, in fact, be higher in a few years may be a subject for another paper.)
The purpose of this paper is three-fold: (1) to demonstrate that a life annuity is financially engineered to maximize the amount of living income payable to retirees; (2) to show the potential impact of deferring annuitization to a later age; and (3) to quantify the impact of delaying an annuity purchase during periods of rising interest rates.
