Podcast Summary: Money For the Rest of Us

Episode: Unlocking Hidden Returns: How Mortality Credits Boost Retirement Income

Host: J. David Stein
Date: February 19, 2025

Overview

In this milestone 500th episode, host J. David Stein explores the concept of “mortality credits” and how they enhance retirement income through annuities. Drawing from his work with a financial planning advisory group, industry literature, and hands-on examples, Stein compares immediate and deferred income annuities to traditional bond ladders, emphasizing the unique and often misunderstood benefits that pooled longevity risk can provide retirees.

Key Discussion Points & Insights

1. Setting the Scene: Annuities in Retirement Planning

• Stein joins a working group examining best practices for advisors, deepening his explorations into annuities, particularly for clients shaken by market downturns.
  • Quote: “I certainly have given a lot of thought to financial planning and advisory practice, especially when it comes to annuities.” (02:20)
• Distinction made between immediate annuities (start paying out right away) and deferred income annuities (payments begin after a set period, e.g., at age 80).

2. Advisor Bias and Annuity Use

• Financial advisors often avoid recommending immediate annuities because their compensation depends on assets under management (AUM).
• There's also skepticism fueled by industry critics (e.g., Fisher Investments’ “Beware of Annuities” ads).
• Stein argues annuities are tools not universally appropriate—but highly effective in the right circumstances.

3. Mortality Credits Explained

• Mortality credit: The extra return annuity holders receive because some peers die early, leaving their share for survivors.
  • Wade Pfau's summary: “Those who fall short of life expectancy… subsidize the income for those who live a long time.” (12:01)
  • Stein’s view: “Mortality credits are a return booster.” (13:50)
• Immediate vs Deferred Annuities:
  • Deferred annuities have higher mortality credits—because more annuitants may pass before payments start, further boosting survivors’ returns.

4. Comparing Annuities to Bond Ladders

• Stein uses the analogy of zero-coupon bonds (no interim interest, just final payout) to describe how insurers fund annuity payments.
  • Quote: “An annuity, be it an immediate annuity or a deferred income annuity, are like a series of zero coupon bonds...” (17:13)
• Deferred annuities can provide higher returns than a comparably safe bond ladder, due to mortality credits.

5. Real-World Example Calculations

Assumptions:

• 65-year-old male, $100,000 investment

  Immediate Annuity:

  • Pays ~$7,776/year for life
  • Life expectancy: 17 years
  • Internal rate of return: 3.8%
  • Quote: “That equates to a 3.8% annualized return.” (26:31)

  Deferred Income Annuity (start at 80):

  • Pays ~$29,496/year starting age 80, for 8 years (life expectancy from 80: 8 years)
  • Internal rate of return: 4.8%
  • Quote: “It's 4.8% annualized. It's a percentage point higher...” (28:38)

• The extra return is due to pooling: many annuitants won’t live to 80, amplifying the survivor payouts.

• Comparable bond ladder (TIPS): $6,900/year, but includes inflation protection.

6. Inflation, Risk, and Annuity Drawbacks

• Immediate annuities typically don’t protect against inflation; their payouts lose real value over time.
• Bond ladders (+TIPS) do protect against inflation, but may yield lower initial payouts.
• The break-even inflation rate concept helps retirees compare the relative benefits between annuities and bond ladders given future inflation uncertainty.
• Quote: “The benefit of the immediate annuity is the guaranteed income for life… because of the mortality credits.” (32:28)

7. Who Should Consider Annuities?

• Immediate annuities: best for those needing current, stable, worry-free income, often not affluent.
• Deferred income annuities: attractive for those who want to maximize mortality credits and are comfortable managing their own assets in early retirement but desire “longevity insurance.”
• Quote (personal reflection): “When I retire and many others, a deferred income annuity could make some sense because I can maximize the mortality credits.” (37:21)

8. Market Rates, Mortality Credits, and Diversification

• Wade Pfau’s insight:
  • In low interest rate environments, mortality credits become even more valuable. While bond yields drop, the ‘return boost’ from mortality credits is unaffected by interest rates.
  • Quote: “The mortality credit component for spending is not impacted by interest rates, it's completely separate.” (41:33)
• Mortality credits offer diversification—distinct from traditional market returns.

Notable Quotes & Memorable Moments

• On annuities as misunderstood, but powerful tools:
  “Insurance products are tools. They can be incredibly helpful if we understand them. But every insurance product isn’t suitable for a given individual.” (06:07)
• On the magic of mortality credits:
  “Mortality credits are the unique return component of annuities… These credits effectively boost the return for survivors.” (13:41)
• On deferred annuities’ power:
  “A deferred income annuity purchased by a 65 year old male today… at age 80, $29,456 compared to $7,776 for the immediate annuity… a 9.2% annualized return.” (39:28)
• On diversification:
  “Mortality credits are a diversifier because it’s not dependent on interest rates… it’s a different return driver.” (43:26)

Important Timestamps

• 02:20 – Stein describes the financial planning working group and his introduction to annuities
• 06:07 – Discussion on why advisors often avoid annuities
• 12:01 – Wade Pfau's definition of mortality credits
• 13:41 – Modern, intuitive description of mortality credits
• 17:13 – Comparing annuities to zero-coupon bonds
• 26:31 – Immediate annuity, rate of return calculation
• 28:38 – Deferred annuity, internal rate of return
• 32:28 – Comparing inflation protection in annuities vs bond ladders
• 37:21 – Stein’s perspective on deferred income annuities for his own retirement
• 41:33 – Mortality credits as interest-rate-independent diversifiers
• 43:26 – Closing reflections and summary

Key Takeaways

• Mortality credits are a source of hidden return in annuities, especially deferred income annuities, due to risk pooling.
• Immediate annuities offer peace of mind and stability, suitable for those with minimal risk tolerance.
• Deferred income annuities maximize mortality credits and act as effective longevity insurance.
• Returns on annuities depend on both market rates and mortality credits—but only mortality credits are uniquely independent from prevailing interest rates.
• Choosing between annuities and bond ladders depends on personal need for guaranteed income, inflation protection, and risk comfort.

This episode serves as a comprehensive guide for retirees and financial planners alike, demystifying annuity products and putting a spotlight on the unique power of mortality credits in optimizing retirement income.