Swedroe: Investors Should Re-Examine Annuity Aversion

August 12, 2016

Numerous academic studies advocate for the partial-to-full annuitization of financial assets. Yet despite the evidence, a majority of investors remain reluctant to annuitize for both behavioral and financial reasons. The reluctance to purchase annuities has been called the “annuity puzzle.” I’ll try to shed some light on why this puzzle exists, as well as offer a solution.

Why Or Why Not Annuitize?

An annuity is not an investment vehicle; rather, it’s an insurance product that protects individuals from a catastrophic risk; specifically, the risk of running out of money in retirement. It allows an individual to convert a lump-sum payment, or a series of premiums, into a stream of income that continues for life. The annuity’s future payments protect an individual from financial market risk and, more importantly, longevity risk (the risk of outliving your assets).

Despite the risk reduction benefits, most individuals still hesitate when it comes to buying annuities. One reason is behavioral. Many investors exhibit what is called “loss aversion.” They feel converting to an annuity “gambles away” their assets should they die earlier than expected, thus leaving their heirs a smaller estate. Another reason is that some investors dislike giving up control of their assets, believing they might do better if the money remained and grew in their investment accounts.

In addition, investors can be deterred by the financial restrictions of some annuities. Because most annuities are illiquid and irreversible, assets can’t be accessed should unexpected needs, such as health-related costs, arise. And once assets are converted, the payouts often cease when the annuity holder dies, leaving nothing for bequest purposes. (Note that annuities can be structured to have minimum payment periods, though this increases their costs.) Unless specific inflation-protected annuities are purchased, fixed payouts may not keep up with inflation. The cost of certain annuities can also be prohibitively high due to a mix of add-on benefit riders, commissions, and management and administrative expenses.

There is yet another reason individuals may not annuitize assets. If they are working with a fee-only advisor (whose fees are based upon assets under management) the advisor might be reluctant to make recommendations that reduce managed assets (and thus his or her income) to the extent that the purchase of an immediate payout annuity would.

In addition to these behavioral reasons, there are other very logical explanations for why most investors don’t (or shouldn’t) purchase immediate annuities. The first is that investors can replicate a payout annuity themselves more efficiently, at least until they reach an age when the mortality credits inside the policy are great enough to offset the issuance costs and the required profit margin of the issuer.

 

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