​The Mechanics of Lifetime Income

By Brad Thomason, CPA
 
 
 
People seem to be publicly upset a lot more these days than used to be the case.  So as I’ve watched that trend over the last few years and thought about it more than I did in the past, I’ve come to think that simple misunderstanding is responsible for a massive portion of the hurt and upset experienced by the human race, the world over.  For so many people in a state of literal outrage, it seems to me that even the tiniest bit of education could perhaps go a really long way.  Understanding how things actually work, and knowing enough to spot erroneous explanations or chains of logic, are important if for no other reason than to tamp down the number of people getting agitated over purely-imagined evils.
 
Well, I don’t think we can change the world.  On the other hand, it is sort of the purpose of this blog to provide clarity on the topics surrounding retirement.
 
With that in mind, I thought it might be beneficial to spend some time talking about the inner-workings of one of the truly foundational models in personal finance, that of the traditional pension.  This has nearly universal application in the US, not so much because every worker has an old-school pension, but because of Social Security, which works on the same basic framework.  So for that alone, it’s a good thing to know something about.
 
But it is also key to understanding what many consider to be a very important option in the retirement planning/management toolbox, the private annuity contract, with a lifetime payout of income.  Well, both understanding it, and avoiding anger-inducing misperceptions about it at the same time.
 
But first, pension basics.  Assume that you have to provide income for a bunch of workers who, on average, live for twenty years after they retire.  So if they retire at sixty five, on average, they all live to be eighty five (which, by the way, is not too far off actual life expectancies for people who have already made it into their sixties.  Note that life expectancy, in laymen’s terms, more or less means the point at which half the group is no longer living.  So half do not live to be 85, and the other half live longer than that.).
 
How much money does that take?  In simplest terms, for each worker, it takes one year of income times twenty years.
 
In reality that’s only the approximate figure because during the twenty years interest will be earned.  Also over the twenty years there will be some inflation, and to keep pace there will have to be some cost of living increases to the payout.  To some extent, those two offset each other though, so to keep life easy let’s just go with $X times 20 for purposes of this simple explanation.
 
It would be mathematically equivalent, more or less, to say that the pension plan has some pool of money for the person, and they are going to divide it into twenty portions, to be paid out one portion at a time.
 
So that’s the first point.  Some pool of money divided by some years of expected payouts.  However, understand that while this basic building block (a pool of money associated with each worker, individually) is a necessary part of the conceptualization process, that’s about as far as it goes.  As we will see, each worker’s pool of money, isn’t really their money; not in the same sense as having a bank account that they can withdraw from whenever they like.  It’s just sort of a gauge to help the pension track the level of resources available to meet the promises it has made.
 
To dig a little deeper, let’s consider the case that there are three workers covered by this plan, one who lives for only ten years, one who lives exactly the prescribed twenty years, and one who makes it thirty years.
 
Note that the wide disparity between these outcomes still reduces to an average lifespan of twenty years past retirement (10+20+30=60 years; 60/3 workers=20 years).  So our overall assumptions for the pension are still intact.  Though what happens individually veers of course rather substantially.
 
The first person does not end up receiving all of the money that the pension fund thought would be paid out.  The third person gets a whole lot more.  And where does the extra come from?  The money that was not paid out in the first case.
 
If we make an assessment of what happened, it goes like this:  all three workers were promised income for life, and all three workers got income for life.  They just didn’t all get the same amount of money (because “get the same amount of money” was never the promise, to begin with).
 
In order to make that possible, the pension plan simply had to have the ability to reallocate in order to fit the facts as they played out over the years (e.g. the death of the first worker).  Simple, but not insignificant.  In fact, that one feature is quite powerful, even critically necessary.  Without the ability to internally shift things around, the entire system could not function as it does.  To really get to the heart of the operation, we need to see the disconnect between what the pension initially allocates to each worker for planning purposes, and what each worker owns and ultimately receives.  That’s the key detail.
 
What’s described above is how the teachers’ retirement folks do it.  It’s what the Social Security Administration does.  It’s also what Medicare does when one person gets really sick in a given year, while five or six others don’t have any significant medical bills to speak of.  It’s what your home owners’ insurer does with the premiums they collect from, say thirty people, when one person has a fire but the other twenty nine people don’t.
 
In all of these cases, the entity managing the coverage shifts resources as necessary to meet the promises they made.  The promise – not the individual payout – is where they deliver the same thing to everyone in the group.  The fact that different group members get different actual payouts may not be an immediately obvious by-product of such a system.  But I think if you’ll think about it for a minute, it will become clear that it really couldn’t be any other way.  It’s the natural result of responding to uncertain outcomes which affect each person a little differently than everyone else.
 
Notably, in the scenarios described above, the “consumers” of those services don’t seem to have much problem with the way things are done.
 
But when the topic turns to purchasing your own life income from an annuity company in a one-on-one transaction, for some reason, everything seems to change.    
 
Probably the number one reason people do not choose the lifetime income option on an annuity contract (which in many cases may be the single most valuable benefit associated with the contract) is the concern that if they die after just a few years, the annuity company will “keep their money.”  If the number of payouts received by the annuity owner prior to death are equal to less than what they paid to purchase the annuity, then they will have made a bad deal.  And perhaps more importantly, the insurance company will have screwed them over by keeping the difference instead of giving it back to the person’s estate.  That’s the perception.  So they don’t do it, sometimes even getting preemptively angry at the very suggestion of it.  If they select an annuity at all, they take a payout for a guaranteed number of years to make sure nothing gets left behind.
 
Which is fine.  Nothing wrong with taking the deal just to collect the interest.  But in so doing, they give up the coverage associated with lifetime income.
 
For the record, I get it.  It is very hard not consider the possibility that you might be spending money, a substantial amount of money in this particular case, on something that will not benefit you in the future.  Even if that is exactly what you’ve already done with every other form of insurance you’ve ever purchased. 
 
But as in all important decisions, you really do need to move past perception, and get to actual substance, before you make the call.  What’s ultimately on the table here is the question of who has financial responsibility for you living past your life expectancy, you or the insurance company?  That’s potentially a really big question. 
 
If you want them to assume that liability, you not only have to pay them to take the risk off your hands, you also have to realize you are entering a much larger equation where they (the insurance company) are having to simultaneously manage and make good on many promises of the sort they made to you.  To do that, they have to have the ability to reallocate resources, just like any other functioning player in these environments does. 
 
In other words, you have to realize that at the point in time you agree to life income, it stops being your money.  It’s the price you pay for the benefits promised as a voluntary member of the coverage group. 
 
If you think that has value, you should consider taking the deal.  If you don’t think it’s a fair trade, don’t take the deal.
 
But either way, I think it is important to be clear-eyed about what’s going on.  Keeps people from getting upset when they actually got exactly what was promised.  It’s also more fair.  Which is not trivial.  Because even though I’m unsure how important it is to insurance companies that people regarded them fairly, I do think that trying to be fair is good for the person doing it.  Call me old fashioned…
 
So there you have it.  A quick primer on the fundamentals of pensions and life income.  For things like Social Security, the situation is what it is and you don’t really get any say in the matter.  But it’s nice to know how things which affect you function. 
 
When it comes to voluntarily establishing an income stream by way of an annuity contract, each person will have to make an individual decision about how much they value the risks and benefits involved, and react/transact accordingly.  Though there may be ample room for different persons to come to different conclusions about those questions, it really doesn’t serve anyone’s interest to accommodate misperceptions about how the basic process works, or assume malign intent on the part of the parties involved with making the machinery work. 
 
Hopefully this piece clears some of that up, making for better decisions, and less risk of this topic being one which generates misunderstanding and the bad feelings that go with it.