Executive Summary
In theory, it seems like such a great idea. The greatest fear of a retiree is living longer than expected and/or outliving his/her money. Only slightly less worrisome is the similar risk that the retiree lives so long that inflation erodes wealth and income to the point that the retiree can't maintain his/her standard of living. Yet there is a single financial services product that tackles these two fears head-on, with rock-solid guarantees (at least as long as you buy from a strong company): the inflation-adjusted immediate annuity. Or for those who are a little older with a shorter time horizon (where inflation is less of an issue), the even-more-widely-available traditional immediate annuity. But despite the apparent "perfection" of the solution to address the problem, immediate annuities are just a tiny fraction of overall annuity sales, and most clients are completely unwilling to put any money into them. So what's the deal? If immediate annuities are such a great solution, why doesn't anyone want to buy one?
The inspiration for today's blog post comes from an email I saw this week sent from a planner who I met attending last year's "Life-Cycle Investing for Financial Planners" conference held at the Boston University School of Management and led by Professor Zvi Bodie. The conference explored the world of Lifecycle Finance, which I would characterize as "financial planning from the economist's perspective" and yielded some very interesting insights about solutions to many common financial planning problems and challenges.
The Annuity Puzzle - Why Don't More Retirees Annuitize Their Portfolios?
One of the common prescriptions for which Lifecycle Finance is known for is its focus on the use of inflation-adjusted immediate annuities as a solution to the dual challenges of longevity and inflation risk, the two greatest dangers to the failure of a retirement plan. After all, the solution is about as perfect as it can get; the goal is lifetime income that keeps pace with inflation, and an inflation-adjusted immediate annuity provides precisely that! Yet the email from my colleague from the conference lamented that in discussing these ideas and issues with some of her clients (and one problematic client in particular), there seemed to be little to no interest from clients to actually purchase such a solution. Instead, the clients just seemed rooted in their "traditional" portfolio investing approach, and/or when looking at annuities were being swayed by various forms of variable annuities, which admittedly provide some similar solutions regarding longevity risk, but typically not with the simplicity and efficiency of an immediate annuity (and usually without a guaranteed inflation-adjustment mechanism, either).
So once again, I ask the question: if the inflation-adjusted immediate annuity is such a perfect solution to longevity and inflation risks (or more generally, the immediate annuity as a solution to longevity risk), why is it that virtually "no one" actually buys these things? (Yes, I realize this is slight hyperbole, as there are some non-trivial amount of immediate annuity sales every year, but relative to the size of the retiree marketplace, it's a tiny drop in the bucket.)
Lack Of Financial Literacy About Annuitization?
To me, it seems there are a few potential reasons. The first is that perhaps we've simply done a terrible job explaining immediate annuities and how they work. Maybe the reason why immediate annuities aren't widely adopted as a retirement income solution is because the general public is uneducated about the product. If only someone would explain to them how immediate annuities work, and showed them how perfectly it answers the retirement income problem, they would be widely used.
Yet the experience of my colleague suggests that this probably isn't the right answer. As she experienced - and as I've witnessed many planners experience - clients frequently reject the immediate annuity even after it has been fully explained. So there has to be something more to it than just "people don't understand how great they are."
The Risks Beyond Just Running Out Of Money
Perhaps the reason immediate annuities are not more widely adopted is because we haven't reasonably understood the risks our clients are concerned about. Yes, outliving money is a common fear. But for many clients, buying an immediate annuity as a solution answers the longevity risk fear, at the "cost" of having no remainder left over as an inheritance for their children/family/friends/charity/etc. Perhaps the immediate annuity just doesn't do a good enough job at balancing longevity risk with legacy goals.
Similarly, for most immediate annuities, payments are fixed for life - or fixed for life with only inflation adjustments - eliminating any further upside opportunity. Notwithstanding the common fear of so many retirees about outliving their money, there is still something oddly disquieting for many retirees to acknowledge that once you annuitize your assets, there's no more upside potential. In other words, the transition to an immediate annuity is like saying "I guarantee this is the best it's ever gonna get." Maybe we have more of a goal and desire to leave ourselves the chance for something better than we acknowledge... even that also entails taking on a material risk that we don't even have enough to meet our original goals.
Irrational Behavioral Finance Decisions And The Fear Of Annuitization
Maybe our problem with immediate annuities lies in our irrationalities. For instance, imagine a proposed retirement income solution for a client as follows: every paycheck for your working years, we're going to take a portion of your income, and allocate it directly to a future retirement annuity. You can't touch the money when it's paid, or at any point thereafter, even if you desperately need it for a dire emergency. Your retirement contribution to the future annuity is mandatory, and it will be a non-trivial portion of your paycheck (e.g., 6%). You can only start the annuity payments when the annuity company says you have reached a reasonable retirement age. If you're married, the annuity payments will be made on a survivorship basis, but if you pass away without a spouse - or are the 2nd to die of the couple - no future payments are made. All of your remaining savings in the retirement annuity are gone. If you're single, you can save (and will, since it's mandatory!) in the retirement annuity for 40 years but if you pass away right before retirement, all of the money is gone and you can't bequeath any of it; the annuity company keeps it.
I suspect if we proposed the above as a solution to retirement, the overwhelming majority of clients would be in an uproar. We're taking away people's opportunity to invest. We're preventing them from leaving legacies for their children. We're not allowing them to have access to their own money. We're forcing them to save in an illiquid investment vehicle they can't use for their needs and have no choice in the matter. Yet when we call it what it is - Social Security retirement benefits - we view the system as a fundamental pillar of retirement income. Odd how quickly our views can change depending on how the information is presented to us, isn't it?
And of course, this isn't our only irrationality in this regard. We have a strong desire to maintain liquidity - a common criticism of the immediate annuity - yet the reality is that most of our liquid funds sit idle for years and decades on end. We insist that choice is good and that we want to be the masters of our own destiny, yet the so-called "Paradox of Choice" reveals that we more often we are actually irrationally paralyzed by having lots of choices, rather than empowered. Similarly, when I suggested a mandatory retirement annuity savings system, many of you probably recoiled; yet when I pointed out that I was simply talking about Social Security retirement benefits, suddenly the idea didn't seem quite as bad. How are we supposed to deal with all this irrationality, where the manner in which the question is framed and the choice is presented has such an overwhelming impact on our views about it?
I'm not certain which of these factors is the driving force about why more clients aren't interested in immediate annuities. Perhaps it's some blend of all of these, including a more complex and nuanced set of goals than just "make sure I don't outlive my money" sprinkled in with some general lack of education (and "mis-"education) about the features and benefits of immediate annuities, and further complicated by all the irrationalities that color the lenses we use to view the problem and its solutions.
Nonetheless, the problem remains apparent: for all that's professed about the ideal nature of the immediate annuity as a solution to the retirement income problem, most people really don't seem to actually want to put their money there. There must be something else factoring into the equation in the client's mind, and the minds of the general public.
So what do you think? Why aren't immediate annuities more popular as a solution to the risk of longevity and outliving your money? What's "getting in the way" of the adoption of immediate annuities as a widespread solution to the retirement income problem?
Michael, I think it has more to do with our perception of reward now vs reward later. These annuities are a classic reward later proposition, and even though they match up well, clients just don’t get enough mental pay-off for making that decision now, vs the perceived loss of flexibility later.
Michael, I think the big fear is tying the money up. What if something better comes along? Will I miss it? Annuities can also be complex. Not only are the buyers confused but many advissers are almost as confused and don’t want to deal with the complexities.
Clients don’t like the idea of giving-up money(and by extension freedom/independence) they’ve worked a lifetime to accumulate. Once you start adding inflation riders and guaranteed payment periods the income amount is close to what you could do taking withdrawals. You’d still have control over your assets without diminishing your estate.
Eric,
True, by the time you layer on a number of guarantees, you end out with an annuity payment stream that is not substantively different than a “safe withdrawal rate” distribution level that generates comparable cash flows while maintaining access to all the assets.
But on the other hand, safe withdrawal rates are built for finite time periods. That research actually assumes you deplete the assets at the end of the (typically-30-year) time horizon. By contrast, the annuity pays “forever”.
So in essence, the payment streams are comparable… except you can still outlive the portfolio, and you can’t outlive the annuity.
So if we don’t buy annuities, does that mean we’re not really that worried about outliving our money after all? Or is there something else going on here?
Michael, solid points here.
I think there is an inherent cost/benefit analysis done by retirees (not explicit, rather more of an inclination) whereby they weigh the possible “risk” of the combination of poor returns and long life vs the benefit of increased flexibility of distributions without an annuity(i.e. Mr. Retiree wants to be able to take $20k in January of 20xx for a new vehicle, which a SPIA doesn’t allow for). That cost/benefit coupled with a disbelief that the worst case (bad returns and long life) will happen to them seems to explain much…at least to me.
I think that annuities work great for providing the amount of income that one needs to cover for basic living expenses (food, shelter, healthcare). The annuity income takes care of the longevity risk of the one true fear that people have “will I have enough?”. Beyond that people want to be in control of their own assets, this is America after all and we have been conditioned to dream big. With the remaining assets one can control their own withdrawal rate (acceptance of risk). In other words; individuals are conservative in regards to some aspects of their income, but not others.
At present, returns on IA’s are paltry. And with the specter of rising rates, I find people less willing to commit substantial portions of their assets for this “income flooring”. I would think layering smaller amounts over time would be a suitable answer, but nobody seems to get it. I also think the overall lack of integrity in the insurance market place causes people to lump annuities together. The higher commission VA’s and FIA’s are over-sold, and a large percentage of individuals selling them are nothing more than greasy peddlers who don’t know what they’re selling – except a 7% paycheck. People are leery. Until the insurance industry requires its producers to be professionals, and flushes out the charlatans, I suppose this will persist. Of course, this won’t happen.
The article & comments provide a number of legitimate reasons people don’t purchase SPIAs.
However, I can’t help but think that lower commissions could also play a significant part. That is, since SPIAs typically pay lower commissions than other products, advisors are less motivated to explain / recommend them to their clients.
Ryan,
Interesting perspective here. I think most people are critical of commissions in annuities being too high, but you make a notable point here that the relatively “low” commission associated with SPIAs actually represents a business challenge for many firms. It is a disincentive to present the option, given the long-term business implications for the “typical” AUM-style firm.
That aside, though, I still think this seems to be a significant challenge, even for those who DO use SPIAs as a primary part of their product offering to clients. Of course, advisors who don’t offer SPIAs aren’t likely to implement many, but those who do offer SPIAs don’t seem to be very successful in implementing them all that much more in practice, either.
Investing in annuities gives the investor huge potential savings due to the how these products are taxed. For example, the money invested in an annuity has the ability to grow, tax-deferred, up to the point that you start taking withdrawals.
Specious argument. Distributions above basis (assuming NQ) are taxed as OI, if instead the assets were invested in individual stocks, low turn-over index funds, and muni bonds with some active tax management one could have a far more preferable (and flexible) distribution strategy.
Lack of tax efficiency (due to floor of OI) and lack of flexibility in terms of when to take money out (most pre retirees I meet with have elastic spending projections) are the main reasons I see for avoiding annuities.
I would suggest that most individuals don’t have a real grasp of risk at the individual level. Individuals don’t experience risk – we experience events and outcomes. The bulk of our industry’s conversations center on probabilities of achieving retirement goals, rather than the range of outcomes and a frank discussion of the consequences of not achieving them. If people actually thought of “risky assets” from an economics perspective, the consequence of not including at least some insured assets in a retirement plan would be absolutely unacceptable. When a discussion of minimally acceptable outcomes precedes the annuity discussion, clients are much more likely to understand why some portion of their portfolio belongs in an annuity, particularly after you have done everything you can to maximize the “cheapest,” most secure, inflation adjusted annuity money can buy – which is Social Security.
Annuities are priced too high relative to life expectancy and the yield curve. Good deal for the insurance companies, but the investors only get about 80-85% of their preimums in return. There’s a reason big buildings in NY, Chicago, etc have insurance companies’ names on them. You can build your own annuity. That’s essentially what we do.
Brent,
A fair point that products like this have an embedded cost. But on the other hand, I don’t see clients saying “You know, I really like this annuity, I just wish it was 10% cheaper and then I’d be buying it.”
In other words, notwithstanding some of the costs embedded, I’m not very convinced this is a cost issue (alone).
Respectfully,
– Michael
Sounds like the Social Security System!
“For instance, imagine a proposed retirement income solution for a client as follows: every paycheck for your working years, we’re going to take a portion of your income, and allocate it directly to a future retirement annuity. You can’t touch the money when it’s paid, or at any point thereafter, even if you desperately need it for a dire emergency. Your retirement contribution to the future annuity is mandatory, and it will be a non-trivial portion of your paycheck (e.g., 6%). You can only start the annuity payments when the annuity company says you have reached a reasonable retirement age. If you’re married, the annuity payments will be made on a survivorship basis, but if you pass away without a spouse – or are the 2nd to die of the couple – no future payments are made. All of your remaining savings in the retirement annuity are gone. If you’re single, you can save (and will, since it’s mandatory!) in the retirement annuity for 40 years but if you pass away right before retirement, all of the money is gone and you can’t bequeath any of it; the annuity company keeps it.”
Michael, so often many financial advisors and the general public miss the annuitization point. It’s not as much about lifetime income as it is about a financial defensive posturing. Annuitization just like Social Security preserves household incomes over very long durations in the face of unexpected dissipation events. However, to “buy” this argument, one has to assume, like at every other age, retirees are not special. They will not make to age 65 then wander happily ever after into the sunset of their twilight years without facing some adversity. The degree of which will set the tone for their remaining lifetimes.
Many individuals/households facing crisis today were once-upon-a-time in the solid middle class with incomes, assets, two Social Security benefits but because of unexpected obstacles in the ”life happens” category, find themselves falling into the lower economic classes. There are several reasons for this: Living longer than expected, out living their savings, non-escalating SSN income, healthcare adverse events, extremely low interest rates, high rates of isolation and being homebound or disabled among others.
Households subject to the above dropped to the lower economic classes simply because their non-annuitized wealth was insufficient to maintain their living standards. Consequently, after slowly dissipating their non-annuitized wealth and losing wealth in the form of lost SSN benefits (when one spouse dies), many former middle class individuals are facing a financial income jam of epic proportions and bleak economic features.
I would argue that the average household is significantly under annuitized. Yet, when opportunity to add to annuitized wealth presents itself at early ages; 40s, 50s, and 60, when assets are sufficient to afford such purchases, many times the opportunity is lost. It’s lost because consumers have not been counseled by convincing agents regarding the long-term importance of producing successful retirement financing via annuitization. Financial portfolios and cash value insurance products’ ultimate lifetime benefit, in the long-run, will depend upon the retiree’s own experience in the intervening 20 – 30 retirement years as much as it will depend on the financial performance of the product itself. However, to ignore the former in favor of only concentrating on the later is a recipe for disaster.