Should You Really Hate Annuities?

You may have heard advertisements that say you’re supposed to hate annuities, but most economists think that retirees should love, and in the right situations use, annuities. Many consumers and even financial advisors are confused about what annuities do and whether they are, in fact, useful.

 

You might already own an annuity

 

Those who hold a negative opinion of annuities may be surprised that they already own one. Social Security is an annuity. An employer pension is an annuity. Think of an income annuity as a long-life income club. You give money to an institution in exchange for a promise of lifetime income for everyone who joins the club. The institution, whether it be a pension manager or an insurance company, invests the money and makes regular payments to the club members.

Retirees who receive a regular paycheck from annuitized income are significantly happier than those who don’t own one. Nearly all experts who study retirement investing believe that more Americans should invest at least a portion of their savings in an annuity. So why is there so much disagreement about the value of an annuity? And why do so few retirees buy an annuity with their 401(k) savings?

Economists refer to the unwillingness to trade a portion of one’s retirement savings for a guaranteed lifetime income stream as “the annuity puzzle.” After all, Professor Menahem Yaari showed mathematically in 1965 that a retiree whose primary goal was income (rather than a legacy) should annuitize their savings.

 

Why is it efficient to annuitize? 

 

None of us know how long we’re going to live. A worker who retires at age 65 may live 10 years, 20 years, 30 years, or even longer. Higher-income Americans are living longer than ever – a Brookings Institute study by Barry Bosworth recently found that men in the top 10th percentile of earnings gained 5.9 years of longevity over a recent 20-year span. Living longer means that we need to pay for more years of spending in retirement.

Today’s retirees will need to fund their lifestyle with their own 401(k) savings. This means they need to estimate how many years they’ll live in retirement and then spread their dollars across each year of life. A healthy 65-year old heterosexual couple may be surprised to know that there is a 50% chance that one of them will live beyond age 93. At today’s low Treasury Bill yields, they’ll need to set aside $245,000 to fund $10,000 of spending through age 93.

Unfortunately, if they spend $10,000 each year, they also have a 50% chance of running out of money by living to age 94. In that case, they should probably set aside more. $295,000 is needed to make sure the money will last until age 100. Is this safe? There is still a 10% chance that one spouse will still be alive. Are you OK with a 10% chance of running out of money? 

 

Enter the annuity

 

Instead of forcing each couple to bear the risk of an unknown lifespan, the insurance company can simply collect a premium equal to the cost of funding an average retirement. Some couples will live to 85. Others will live to 100. Those who did not live as long will subsidize those who live longer. This is the essence of insurance. We don’t know if our retirement will be expensive in advance, so we’re better off joining the club and pooling our savings with other retirees.

Using an immediate online annuity quote generator, we see that it costs $192,000 to buy a lifetime income of $10,000 for a 65-year old couple that provides income for a minimum of 10 years, even if the couple dies before age 75. The retiree’s choice is to either set aside $295,000 in Treasury bonds and bear a 10% chance of outliving their savings, or set aside $192,000 to receive income for a lifetime. This is why economists refer to the failure to annuitize as a puzzle. 

 

How does the insurance company invest the club members’ money? 

 

In a simple fixed income annuity, the insurance company needs to pay a specific guaranteed income amount in the future. This means that they can’t invest in risky assets like stocks whose returns vary over time. Retirees should also think of their spending budget as a combination of fixed and variable expenses. If their spending needs are fixed, stocks aren’t an appropriate investment. You can’t renegotiate a property tax payment because of a bear market’s effect on a stock portfolio.

Without the ability to annuitize, a retiree faces a simple choice: they can spend very little to reduce the probability of outliving savings, or they can spend more and risk running out of money. An income annuity provides a third choice of spending more and eliminating the risk of outliving savings. If a retiree can spend more and not have to worry about outliving savings, why wouldn’t they annuitize?

This annuity example is based on a simple income annuity – the kind economists generally think of when they talk about annuities. Some financial products that bear the name of annuity are more complex. It is this category of products, which include variable or index annuities, that has borne the brunt of criticism by those who point to abusive sales practices and hidden, potentially excessive expenses.

 

Like all financial products, variable annuities have a range of characteristics and expenses 

 

The original variable annuity was created in 1952 to give teachers lifetime income with the long-term inflation protection provided by investing in both stocks and bonds. Some variable annuities are highly competitive, providing exposure to risk in order to generate a possibly higher income in retirement, while others deserve their reputation as an expensive, inefficient black box. 

Many annuity products also incorporate complex features that employ financial options to protect workers against the very real risk of a market crash right before retirement. Hopefully, the market for income-producing investments will expand as Baby Boomers who do not have a pension look for ways to generate lifetime income. Ideally, a new retiree should be able to confidently shop around for the annuity that best meets their willingness to accept investment risk at the lowest price. 

Should you hate annuities? Of course not. Think of an annuity as a category of financial products created to do something the individual can’t do on their own. A mutual fund allows an investor to own a diversified portfolio of hundreds of stocks with only a small investment. An annuity allows investors to pool their money together to provide a lifetime income. And like a mutual fund, there are more efficient options that can give individuals the ability to turn a portion of their 401(k) nest egg into a secure lifestyle in retirement.

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