“Retirement alpha” makes a retirement portfolio all that it can and should be, said author and insurance veteran Tom Hegna at the 11th annual Inside Retirement conference.

A former senior executive officer for New York Life and author, most recently of "Don't Worry, Retire Happy! Seven Steps to Retirement Security," Hegna gave a presentation called “Retirement Alpha: How Mortality Credits Improve Retirement Outcomes.”

Just as “investment alpha” is defined as excess performance over a period of time, he explained, retirement alpha describes getting extra value from a retirement portfolio.

The way to get that extra value, he said, is by including income annuities.

Whether single premium immediate annuities (SPIAs) or deferred income annuities (DIAs), income annuities are the best—indeed, the only—way to guarantee a long and happy retirement, he said. They are the key to “building the most efficient retirement portfolio possible,” he said. “That’s really what retirement alpha is.”

Income annuities do this in several ways, he continued. First, they provide uncorrelated cash flow that is guaranteed regardless of how markets perform or interest rates fluctuate. As such, they are a hedge against volatility. Second, they provide longevity insurance, meaning you cannot outlive the income stream even if medical science cures all illnesses and you live to 150, he said. Third, they offer a degree of liquidity.

But perhaps most of all, income annuities have mortality credits, he said, a benefit that only life insurance companies can manufacture.

They essentially refer to the extra money you get from being part of a risk pool. The mortality credits come primarily from other annuity holders who died younger than expected.

Because of these mortality credits, the payout rates from income annuities "are significantly higher than you can get from bonds," he said. “That’s why they work so well in a retirement portfolio.”

That's true even now that bond rates have risen, he noted. 

Annuity payouts are not interest rates or yields, he stressed. They are a separate, contractually guaranteed amount.

Every check from an annuity is made up of three parts, he said: a piece of the principal, interest or investment gain, and the mortality credits. He called mortality credits “the secret sauce.”

Even when the principal is used up, the checks keep coming for life. That’s because of the mortality credits, he said, adding, “That’s the retirement alpha that we’re talking about.”

Mortality credits are part of every type of annuity that has a guaranteed lifetime income benefit, he said, including indexed annuities that link principal to a market index and mutual-fund-like variable annuities with income- or withdrawal-benefit riders.

Hegna acknowledged that a lot people object to annuities. Some say they cost too much. But income annuities don’t actually charge extra fees, he insisted. Instead, they profit from the spread between premiums and payouts. If someone buys a life insurance policy and dies sooner than expected, the insurance company will lose money. But if the customer lives a long life, the insurance carrier can invest the premiums for longer while paying out nothing. That’s how it makes money, and that’s how it can afford to offer lifetime income.

Other critics contend that you can make more money in stocks. “Don’t compare annuities—especially income annuities—to stocks!” he said. “They are not stock substitutes. They are bond substitutes.”

But there is another benefit to income annuities, he said.

Many retired people hang on to their assets and are afraid to spend money. Many will say they want to save it for their kids. “But you’re not supposed to save your assets for your kids,” said Hegna. “That’s what you buy life insurance for. You’re supposed to be able to use your assets to enjoy your retirement.”

Other retirees may overspend or withdraw too much from their portfolio. If they have an income annuity that can cover all of their living expenses, however, they won’t need to withdraw so much from their savings, he said. “Annuities help you maintain control,” he said.

Finally, Hegna cited research showing that retirees who have the kind of guaranteed lifetime income that only income annuities can provide are actually happier. “All retirees are happier if they have some guaranteed retirement income,” he said.

In sum, their portfolios do better because they don’t have to take excessive withdrawals from them. Their lives are better, too, because they know how much income they will receive for life. Consequently, they know how much to spend on activities that make them happy.

Asked how this income-annuity strategy compares to a bond ladder, Hegna said bond ladders may be fine when interest rates are 7% or higher, but “the annuity will always have a higher payout rate.”

You cannot create an annuity equivalent with bonds, options, futures, hedge funds or anything else, he stressed. “No other investment vehicle can guarantee more payout per dollar invested than an income annuity,” he said.

“If you don’t like annuities, then you don’t like Social Security or pensions,” he added.