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.
What The Research Says
By way of example, the 2001 study, “Optimal Annuitization Policies: Analysis of the Options,” by Moshe Milevsky of York University, concluded that a 65-year-old woman has an 85% chance of being able to beat the rate of return from a life annuity until age 80. For men, the figure was 80%. (Keep in mind that the insurance companies that issue these policies are aware they are being adversely selected, meaning that the most likely buyers of longevity insurance are those with good reason to believe they will live a longer-than-average life.)
There’s another logical reason to consider. It makes sense to insure against events that have a low likelihood of occurring, but if they did happen would have large negative impact (the “Pascal’s wager” problem, where the consequences of decisions should dominate the probability of the outcome).
For example, we buy life insurance when we have young children, even though we know the odds of dying are relatively low. In addition, we buy homeowners insurance, where the risk of loss from a fire is about 1%, because the consequences of that loss are too great to bear on our own. Similarly, we buy automobile insurance even though the risk of an accident is small. In each case, we logically choose to pool low-probability but high-consequence risks by purchasing insurance. And the premiums are relatively low because the odds of occurrence are low.
On the other hand, we don’t buy insurance for highly likely events. Instead, we budget for them. In other words, we don’t buy insurance to protect us against risks that we can manage with our financial assets. For example, we don’t buy insurance for regular car maintenance, such as an oil change. And we can use deductibles to minimize the costs of homeowners and auto policies. Don Ezra discusses these concepts more in-depth in his article, “Most People Need Longevity Insurance Rather than an Immediate Annuity,” which appears in the March/April 2016 issue of Financial Analysts Journal.
Let’s apply these principles to the decision to buy annuities. By definition, assuming average health, we should expect to live to the median life expectancy. Currently, the average, healthy male (female) at age 65 has a 50% change of living beyond the age of 85 (88). Thus, living to about that age is a high-probability event. This then begs the question: Why purchase an annuity (insurance) for that high-probability event? You shouldn’t. Instead, you should be budgeting for it.
However, you should also at least consider buying a deferred annuity, with payouts beginning at age 85. The period between 65 and 85 is like the deductible on your home and auto policy—it’s the risk you should budget for. The deferred annuity (also referred to as a longevity annuity) allows you to insure against only the lower-probability event with high negative impact. By not insuring against the high-probability event (living to life expectancy), we keep the cost of insurance as low as possible.
Longevity annuities are a recent product that begins payments after a specific age, say, 85 (most contracts allow for the choice of a payout age from 50-85). The benefit to having payments occur after the annuitant reaches age 85 is lower costs for larger payouts. The higher payouts are due to increased mortality credits at the end of life and the extended period of time before an annuitant begins to receive the deferred payments. So the later the start date, the higher the payments will be.
A study by Jason Scott, “The Longevity Annuity: An Annuity for Everyone?”, which appeared in the January/February 2008 issue of Financial Analysts Journal, found that for the same spending benefit, a 65-year-old with $1 million in financial assets purchasing an immediate annuity would have to annuitize more than 60% of his/her retirement assets, versus just 11% of his/her assets for a longevity annuity with the payouts beginning at age 85.
Scott also found significant improvements in spending benefits. He calculated a “longevity annuity benefit multiple,” defined as the ratio of longevity annuity spending improvement to immediate annuity spending improvement. He found that for men, the benefit ratio in terms of nominal spending favored the longevity annuity by more than 6:1, and for women by more than 5:1.
Longevity annuities are like traditional forms of insurance in which individuals purchase the contracts for protection and may never need them. Because the longevity annuity can greatly reduce the amount of assets that must be spent to generate a specified amount of cash flow, they address two main reasons why individuals have not purchased annuities: the loss of a large part of their estate; and the loss of liquidity to address unexpected spending needs. And that should help solve the annuity puzzle.
There’s a third type of annuity that we have not discussed: variable annuities.
Variable annuities (VAs) provide payouts typically linked to mutual funds that invest in stocks, bonds and/or money market instruments. Because the value of underlying assets can fluctuate, so do the periodic payouts to the annuitant. VAs are a tax-deferred asset, and investors can continue to grow their assets tax-deferred through a VA while simultaneously ensuring a future stream of income.
However, VA benefits can be easily eroded by commissions to financial advisors, high account fees, higher income tax rates versus capital gains rates, the loss of the ability to harvest losses, the loss of the ability to step-up the tax basis to beneficiaries and, for foreign investments, the loss of the foreign tax credit.
That’s why I call them a product that was meant to be sold, but not bought. Investors seeking the benefits of VAs are almost always better off investing in low-cost, tax-efficient, passively managed mutual funds. Investors with an inappropriate VA should complete a 1035 exchange to a lower-cost VA annuity (through a provider such as Vanguard).
The bottom line is that, while the literature often refers to the apparent underutilization of payout annuities as a puzzle, this puzzle is solved by understanding that deferred annuities—the superior choice for most investors—weren’t available until relatively recently. As investors are educated about the benefits of this product, use should increase.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.