More About Annuities, Risk and Reward

In yesterday’s post, I used Mr./Ms. Anonymous’s comment as an excuse to spout off about investment risk. What can one say about the risk of the insurer who issues your annuity becoming insolvent?

There are too many facets of risk to easily compare the risk-reward matrix presented by an annuity to the risk-reward matrix presented by other investment options.

But you can at least make a start by looking at the reward side of the matrix. Ask yourself this: How much more of an income can an annuity provide than you can expect from a well-diversified pot of assets? In the paper by Almeida and Fornia cited in March 9’s post, the authors attempted to quantify the reward side by noting that money contributed to a pension plan (which is similar to an annuity) might be expected to provide an employee with a 46% greater income in the long run. In their book, Coming Up Short: The Challenge of 401(k) Plans, Alicia H. Munnell and Annika Sunden cite a study which reached a similar conclusion: dollars committed to an annuity might be expected to buy you a 45% greater income than the stream of payments you can fashion for yourself out of a well-invested savings bucket. (Munnell and Sunden are (or were) with Boston College’s Center for Retirement Research, a great source of retirement wisdom and perspective. Its website is here: http://crr.bc.edu/.)

46% and 45%. These are big numbers. In fact, they seem a bit on the high side, but nonetheless there is clearly some meaningful retirement income premium provided by an annuity, a pretty good reward for the particular risks you incur in relying on the solvency of the insurer.

So why doesn’t everybody buy annuities? Nobody knows. In fact, academics have even given that question a name: The Annuity Puzzle. Here are a couple of reasons:

First, a pure annuity leaves nothing for your kids after the death of you and your spouse; whereas taking distributions from your savings buckets will necessarily leave your kids an inheritance. Why? Because you’ll be too cautious in your distributions to ever let your savings buckets run dry. So that forbearance, which contributes to such a measly retirement distribution to you, also contributes to an inheritance for your kids. Think of it as a by-product of your retirement spending plan; an unintentional inheritance. If like many, you’re struggling to provide yourself a decent retirement, you might ascribe no value to that inheritance, and focus instead on strictly what you can expect to spend during your lifetime. (After all, those rotten kids, they never write, they never call.)

Second, you would never use 100% of your savings buckets to buy annuities. Why? Because while the primary purpose of your savings buckets is to provide a source of lifestyle spending during your retirement, they also serve an important secondary purpose: to provide a pot of assets in case of an unexpected emergency. But if you commit them all to annuities, your access to that capital would be cut off, or at least severely impeded.

Third, you give up too much control. Who wants to lose the ability to invest all their assets, and to spend them at the rate she sees fit?

Fourth, most annuities don’t protect against inflation. So they in effect provide a shrinking annual payment when expressed in real inflation-adjusted dollars. Some insurers, however, offer an annuity which increases with inflation—an alternative which should be seriously considered.

Fifth, annuities are expensive and opaque. It’s hard to know what their embedded costs are, or if the insurance company is giving you a fair shake.

Notwithstanding these downsides, and the risk of the insurer’s default, depending on your circumstances, it may be wise to invest a portion of your savings buckets in an annuity. How big a portion? Here is one way to adress the question from two different perspectives. First, figure out your personal poverty level—how much income does it take to meet your bare bones living expenses—subtract what you expect from Social Security and your employers’ pensions, and ask how much it takes to annuitize the balance. Second, project what percentage of your savings buckets you will be investing in fixed income during your retirement. Consider an inflation-adjusted annuity for the lesser of the two amounts.

Then invest the rest of your assets wisely.