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An Age-Old Puzzle

John Lim, 2:53 am ET

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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John Wood
John Wood
6 days ago

A “Refund Installment Annuity” would ensure that either you or your heirs would withdraw at least all of your principal deposit, so there’s no reason to fear that bus.
The biggest challenge to immediate annuities, at the moment, is that it takes so much capital to generate a reasonable income stream in this interest rate environment.
Of the many ways that the Fed is picking the pocket of savers for the benefit of borrowers, this is one of the more noticeable ones.

manager
manager
9 days ago

Don’t be afraid of using a “stock” portfolio from which to pull income. Research shows that a portfolio / index representative of the Large cap “value” universe has sustained a “7%” inflation adj annual withdrawal rate ( “sale of shares”, dividends reinvested ), accompanied by terminal portfolio growth, over seventy one rolling 20 year periods since 1932 https://tinyurl.com/y6key3v5 . That is a long track record of income harvesting and performance – much longer than the inception of annuities. And will an annuity “grow” over time ?

A modern investor is fortunate to have available well diversified, large cap value index funds ( such as the low expense Vanguard Value ( VTV ) mentioned, the DFA Large Cap Value, Fidelity Value Factor, etc. ), which may be used for this purpose. 

Purple Rain
Purple Rain
10 days ago

“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.”

Nail hit head. Why would I hand over a non-returnable chunk of money to someone who will invest in stocks and bonds the same way I can? My dividend growth portfolio that is automatically indexed to inflation is my annuity. I get to keep the principal and enjoy the income. Moreover, I get to leave the principal to charity after I am gone.

John Wood
John Wood
6 days ago
Reply to  Purple Rain

An immediate annuity is a risk-transfer product, where one deposits money with an insurance company in exchange for a contractually guaranteed income stream for life, with the insurance company taking on all of the sequence-of-return and bear market risk. Your points on investment income are valid, with the caveat that you’re bearing considerably more risk for that income than the annuity buyer. As far as the inflation argument, the point of an immediate annuity is to address one’s current income need, so that the rest of the portfolio can be invested more aggressively to address the inflation risk.

parkslope
parkslope
10 days ago
Reply to  Purple Rain

Because an immediate fixed annuity will almost surely provide you with an immediate income stream that is larger (although inflation will reduce the difference over time) and it also has a lower risk than a dividend growth portfolio.

Last edited 10 days ago by parkslope
Carl Book
Carl Book
6 days ago
Reply to  parkslope

Maybe annuities make sense for some people, but for a lot of us with pensions and SSA, they don’t make sense. I can manage my portfolio withdrawals so as to keep my portfolio from declining. Annuities only make sense for someone who must insure against the risk of running out of money, but it is an expensive option.

mytimetotravel
mytimetotravel
10 days ago

I would be delighted to buy an annuity, IF AND ONLY IF it had inflation protection. I already have a pension with no COLA, I can’t afford to add to that problem. If I had bought a SPIA last year, I would already have suffered 5% or so inflation and equivalent loss of buying power. You name me a solid company offering SPIAs with full inflation protection and I’ll seriously consider buying one, otherwise, no. (I don’t care about dying six months after I buy one, any more than I cared about “missing out” on SS benefits when I waited until 70.)

parkslope
parkslope
10 days ago
Reply to  mytimetotravel

Most companies that offer annuities without inflation protection also offer them with annual percentage increases that usually range from 1%-3%. You can also protect yourself from inflation by purchasing an immediate fixed annuity plus staggered deferred annuities.

mytimetotravel
mytimetotravel
10 days ago
Reply to  parkslope

When I said “inflation protection” I meant an increase that reflects the ACTUAL rate of inflation, as with Social Security. Buying a 1% rider and then having inflation hit 5% is of little benefit. Do you know of solid company currently selling an inflation-indexed SPIA?

parkslope
parkslope
8 days ago
Reply to  mytimetotravel

You can buy an inflation-protected annuity but the cost may not be worth it. There is no free lunch in investing and companies price the additional cost of providing inflation adjustments so that it favors them.
https://www.investopedia.com/terms/i/inflationprotectedannuity.asp

mytimetotravel
mytimetotravel
8 days ago
Reply to  parkslope

Still waiting for a link to an actual, solid, company selling one that I could buy as an individual.

David Powell
David Powell
6 days ago
Reply to  mytimetotravel

It’s not as highly rated as NY Life or Mass Mutual, but Principal sells income annuities (immediate or deferred) with an optional inflation rider: https://www.principal.com/individuals/build-your-knowledge/annuity-basics-income-annuity-right-you

Many companies selling annuities will quote policies with annual COLAs up to 4%. If you look at the last 120 years of US inflation data, 3% or 4% mitigates much of this risk. And having your fixed expenses covered by a pension or annuity plus Social Security enables many to hold a higher portion of their retirement portfolio in stocks, which also helps with inflation risk.

mytimetotravel
mytimetotravel
5 days ago
Reply to  David Powell

That link is to a general description of annuities, it does not tell me what the company is actually selling. It appears that even to get information the company requires me to use a “financial professional”, which I will not do.

Again, I want to purchase as an individual, an annuity that is inflation-indexed,not with a fixed percentage rider. (I lived through the 70s, the average of the last 120 years is irrelevant to me.)

R Quinn
R Quinn
10 days ago

The answer, while perhaps not logical, is simple. I give an insurer $250,000 and collect $x a month, but i die six months later and poof my money is profit for the insurer. That’s what most people think.

An income stream is highly desirable, essential in my way of thinking, but not only is it hard to spend savings, it’s harder to turn them over to others too.

I have long thought the way around the problem is to use a 401k or IRA to periodically invest in an annuity over the years as an investment option in the plan. Perhaps the worker could designate just the employer match to the annuity.

The value as an annuity would build up gradually with no need to let go of a large lump sum at any point.

In essence the worker would be partially self-funding a defined benefit pension within a defined contribution plan. They could then retire with the 401k cash plus an annuity stream.

parkslope
parkslope
10 days ago
Reply to  R Quinn

My wife and I are fortunate to allocated a substantial amount of our 403(b) contributions to TIAA’s annuity throughout our careers as educators. Now that we are retired we have several annuity options. Because we have accumulated more wealth than we thought we would, we have chosen to simply withdraw our RMDs each year which turns out to be about the same as the 3%-4% interest that our balances are earning. While we are forgoing the additional incomes we would receive from converting to immediate fixed annuities, we are also “forgoing” having our money go to TIAA when we die.

Last edited 10 days ago by parkslope
kristinehayes2014
kristinehayes2014
9 days ago
Reply to  parkslope

I too have a substantial percentage of my retirement portfolio in the TIAA “traditional” account. I like that it offers so many different ways to take withdrawals.

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