An Age-Old Puzzle

John Lim

ONE OF THE GREAT mysteries in finance is the reluctance of retirees to annuitize more of their portfolio. Annuities—and here I’m referring to plain-vanilla income annuities—provide a guaranteed income stream for life. Examples include Social Security and company pensions. Income annuities can also be purchased from insurance companies. When you buy an immediate-fixed annuity from an insurer, you exchange a lump sum for a guaranteed, monthly payout for the remainder of your life and, in some cases, the life of your spouse as well.

There are many benefits to annuitizing a portion of our retirement savings. Annuities reduce longevity risk—the risk that we’ll outlive our nest egg. They also lower sequence-of-return risk, which is the risk that poor market returns early in retirement will do permanent damage to a portfolio, even if subsequent market returns are generous.

In addition, annuities can generate higher income than bonds. This is accomplished by pooling risk and leveraging mortality credits. The term “mortality credits” is a euphemism for the money left over when those who annuitize die earlier than expected. In essence, they fund the payouts to the lucky annuitants who live much longer than average. In fact, it is precisely this fear—the fear of getting hit by a bus on the way home after purchasing an annuity—that plagues the minds of would-be annuity buyers.

Income annuities simplify life for retirees. Rather than worry about the optimal asset allocation or adjusting spending based on portfolio returns, annuity owners simply receive a monthly check in the mail and get on with life. Having guaranteed income—in the form of Social Security, a pension or an annuity, or a combination thereof—to cover fixed expenses can be a huge boon in retirement. This simplicity is particularly valuable late in life, when waning mental faculties or, worse yet, dementia become increasing realities.

Given the many benefits of income annuities, it’s long puzzled financial experts and academicians that so few Americans purchase them. In fact, this conundrum has a name: the annuity puzzle. A recent paper by David Blanchett and Michael Finke highlights a major downside of the annuity puzzle, which is the tendency of retirees to significantly underspend when their savings are tied up in traditional assets such as stocks and bonds. As they put it, “Retirees will spend twice as much each year in retirement if they shift investment assets into guaranteed income wealth”—in other words, into annuities.

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