The "Annuity Puzzle" Explained - by Scott Stolz, CFP, RICP (week 43)

 

Transamerica’s Center for Retirement Studies asked 2,690 retirees to identify their greatest fears in retirement.  Of the eleven most commonly sited fears, six of them are directly related to having enough money in retirement.

Despite this fear, the same study found that only 22% of the respondents indicated that they own an annuity – the only financial vehicle other than social security and a pension that can provide income for life.  In academic circles, this has been labeled the “annuity puzzle.”  Simply put, even though multiple studies have shown that about 70% of those surveyed find the concept of protected lifetime income attractive, relatively few people actually end up utilizing annuities to provide that income.  Why is that?

In my view, there are 3 primary reasons:

1.      While people like the idea of creating a pension, few want to actually pay to create one.

You spend your whole life building a retirement nest egg.  You’ve patiently watched it grow.  Seeing that number on a statement each month is very reassuring.  As long as that amount exists, you won’t run out of money.  Turning over a chunk of that to an insurance company in order to create your own personal pension, is a difficult thing to do.  Recognizing this, insurance companies created lifetime income benefits.  These are essentially guaranteed systematic withdrawals.  Typically, they allow you to take 5-6% of your annuity each year for as long as you live.  If your withdrawals fully liquidate your annuity, the insurance company is obligated to continue to send you your income out of its own pocket.  But, while the income is guaranteed, the original investment value is not.  Like the 4% rule, you run the risk of reducing your retirement portfolio.  And people just don’t want to do that. As I’ve mentioned in previous blogs, this is one of the reasons so many retirees “underspend” in retirement.

2    Misconceptions about annuities

You don’t have to look very hard to find criticisms of annuities.  In fact, some investment professionals go as far as saying no one should ever buy an annuity because they are complex, costly, and illiquid.  In my view, this is a gross over generalization. 

·       Complexity – Most annuities come with optional features.  Each of these features both add flexibility and complexity.  But many structures are really quite simple.  A guarantee of 5% per year for 5 years is hardly complex.  Nor is a promise to pay $6,000 per year for life in exchange for $100,000.  The bottom line is that complexity does not equal bad.  It just means that like any financial solution, it’s important to take the time to fully understand what you are buying.   

·       Costly - If someone says that annuities can cost 3-4% per year, they are referring only to variable annuities.  More precisely, they are referring to variable annuities with optional features added.  Fixed, indexed, and registered index linked annuities without a lifetime income benefit have no fees deducted from the account value.  If you add a lifetime income benefit providing the guaranteed income described above, you can expect to pay 1-1.5% per year.  Essentially, it’s the insurance premium you pay to guarantee an income for life. 

·       Illiquid – Over 90% of the annuities that are sold pay a commission to the agent that sells them.  However, this commission is not deducted from the amount invested.  The insurance company fronts the commission and deposits 100% of the purchaser’s money into the contract.  It takes 5-10 years for the insurance company to make enough money on the annuity to recover that commission.  Therefore, the companies protect themselves by charging a fee if the contract is liquidated in the first 5-10 years.  This fee typically starts at 5-7% and declines by 1% each year.  Because of this fee, many consider annuities as illiquid investments.  Certainly, no one likes to pay such a fee.  And I would never suggest anyone buy an annuity unless they plan to hold it at least as long as the period this fee exists.  In fact, in almost every case, an annuity buyer should have at least a 10-year time horizon.  But it overstates it to say annuities are illiquid.  In an emergency, you can always get the vast majority of your money.  In order to keep the annuity critics from flinging arrows at me, I should also mention that if you cash in an annuity, you may also have to pay taxes on any earnings and if you are not 59 ½, you may have an additional 10% tax penalty like an IRA.

The point is that sweeping statements such as “annuities are complex, costly, and illiquid” incorrectly put all annuities in the same box.

 3.      People Under Value Protected Lifetime Income

Quick math question: If a 65-year-old male is receiving $2,500 per month in Social Security benefits, how much is that stream of income worth in today’s dollars?  If you guessed about $400,000 you ace today’s quiz.  However, if you are like most people, you probably came up with a much lower number.  The reality is that most investors significantly underestimate the value of a lifetime stream of income.  As a side note, once you realize just how much it costs to pay someone even $2,500 per month for life, you get a better understanding of why Social Security is facing a financial shortfall.  The point is that it’s hard enough to wrap your mind around converting part of your retirement nest egg into lifetime income.  It’s doubly hard if you expect it to provide you with significantly more income than is realistic.

The Bottom Line

I was in the financial services business for over 4 decades.  I am a Certified Financial Planner as well as a Retirement Income Certified Professional.  I can put together an investment portfolio that has a very high probability of sustaining itself throughout my retirement.  Despite that, I have three different annuities that will provide the bulk of my retirement income.  Why?  Because it’s only a “very high” probability.  It comes without a moat, and therefore in this chaotic and uncertain world we live in, I’m going to keep asking, “but, what if?”.  I don’t want to have to worry about what the market does from week to week.  I’m guessing I’m not alone.