This discussion has been fairly positive with regard to the role of income annuities as a retirement income tool. My explanations follow standard academic theory regarding income annuities and their role in pooling longevity risk and providing mortality credits. Without this risk pooling, retirees must be needlessly conservative in their spending to ensure they still have something left if they live well beyond their life expectancy.
For this reason, economists have long wondered why people do not make greater use of income annuities as retirement income tools. Often cited in connection with this bafflement are Menahem Yaari’s research from 1965 about spending for an uncertain lifetime, and Franco Modigliani’s Nobel Prize acceptance speech addressing the subject in 1985.
In The 7 Most Important Equations for Your Retirement, Moshe Milevsky described this mystery in the words of Wharton professor Solomon Huebner, the founder of The American College, who first defined the basic puzzle in the 1930s:
The prospect, amounting almost to a terror, of living too long makes necessary the keeping of the entire principal intact to the very end, so that, as a final wind-up, the savings of a lifetime, which the owner does not dare to enjoy, will pass as an inheritance to others. In view of these facts, it is surprising that so few have undertaken to enjoy, without fear, the fruits of the limited competency they have succeeded in accumulating. This can be done only through annuities … Why exist on $600, assuming 3 percent interest on $20,000, and then live in fear, when $1,600 may be obtained annually at age sixty-five, through an annuity for all of life and minus all the fear?
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The annuity puzzle, as defined by academic economists, regards why income annuities are not more widely used. Numerous explanations have been offered, some more legitimate than others. One obvious starting point for resolving the puzzle is that many retirees may wish to build a legacy. Maximizing personal spending is not the only goal. The desire to leave a legacy may be a strong deterrent from annuitizing for those who have not fully thought through the implications of different alternative approaches that do not include annuities. When not accounting for the other retirement liabilities that must be funded, it is easy to conclude that investments can support the largest legacy. We explain the problem with this conclusion in Chapter 8.
It is important to also think about the dual impacts of investment volatility. One might expect the uncertainty of investment returns to motivate greater annuity use as a protection, but there could be another countervailing force at work. Income annuities remove downside risks, but they also eliminate upside for those assets. The annuity decision carries a sense of finality as one is forever removing the possibility of picking the next winning stock and striking it rich. For hopeful retirees, that loss of potential financial betterment can be a deal breaker. It is important to remember, though, that an annuity is not an all-or-nothing decision.
What’s more, real-world annuities will have overhead charges as insurance providers must cover expenses, make a profit, and account for adverse selection and misestimation risks. These costs reduce payout rates and the potential gains from annuitization. Nonetheless, as we have discussed, the fees built into income annuities do not appear as large as may be commonly thought.
In addition, the standard economics model does not ascribe importance to the idea that retirees may value the ability to maintain flexibility and control over their financial wealth. Preferences, needs, and circumstances may change, so holding off on making the irreversible decision to annuitize holds value for many. The extra control may be partly an illusion, since retirees face spending needs that must be met and risks of wealth depletion that must be mitigated. Nonetheless, the behavioral need to feel like one is in control is important. Income annuities may create the perception that one is losing control over their hard-earned assets.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon
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