In theory, it seems like such a great idea. The greatest fear of a retiree is living longer than expected and/or outliving his/her money. Only slightly less worrisome is the similar risk that the retiree lives so long that inflation erodes wealth and income to the point that the retiree can't maintain his/her standard of living. Yet there is a single financial services product that tackles these two fears head-on, with rock-solid guarantees (at least as long as you buy from a strong company): the inflation-adjusted immediate annuity. Or for those who are a little older with a shorter time horizon (where inflation is less of an issue), the even-more-widely-available traditional immediate annuity. But despite the apparent "perfection" of the solution to address the problem, immediate annuities are just a tiny fraction of overall annuity sales, and most clients are completely unwilling to put any money into them. So what's the deal? If immediate annuities are such a great solution, why doesn't anyone want to buy one?
Wednesday, February 2. 2011
One of the common prescriptions for which Lifecycle Finance is known for is its focus on the use of inflation-adjusted immediate annuities as a solution to the dual challenges of longevity and inflation risk, the two greatest dangers to the failure of a retirement plan. After all, the solution is about as perfect as it can get; the goal is lifetime income that keeps pace with inflation, and an inflation-adjusted immediate annuity provides precisely that! Yet the email from my colleague from the conference lamented that in discussing these ideas and issues with some of her clients (and one problematic client in particular), there seemed to be little to no interest from clients to actually purchase such a solution. Instead, the clients just seemed rooted in their "traditional" portfolio investing approach, and/or when looking at annuities were being swayed by various forms of variable annuities, which admittedly provide some similar solutions regarding longevity risk, but typically not with the simplicity and efficiency of an immediate annuity (and usually without a guaranteed inflation-adjustment mechanism, either).
So once again, I ask the question: if the inflation-adjusted immediate annuity is such a perfect solution to longevity and inflation risks (or more generally, the immediate annuity as a solution to longevity risk), why is it that virtually "no one" actually buys these things? (Yes, I realize this is slight hyperbole, as there are some non-trivial amount of immediate annuity sales every year, but relative to the size of the retiree marketplace, it's a tiny drop in the bucket.)
To me, it seems there are a few potential reasons. The first is that perhaps we've simply done a terrible job explaining immediate annuities and how they work. Maybe the reason why immediate annuities aren't widely adopted as a retirement income solution is because the general public is uneducated about the product. If only someone would explain to them how immediate annuities work, and showed them how perfectly it answers the retirement income problem, they would be widely used.
Yet the experience of my colleague suggests that this probably isn't the right answer. As she experienced - and as I've witnessed many planners experience - clients frequently reject the immediate annuity even after it has been fully explained. So there has to be something more to it than just "people don't understand how great they are."
Perhaps the reason immediate annuities are not more widely adopted is because we haven't reasonably understood the risks our clients are concerned about. Yes, outliving money is a common fear. But for many clients, buying an immediate annuity as a solution answers the longevity risk fear, at the "cost" of having no remainder left over as an inheritance for their children/family/friends/charity/etc. Perhaps the immediate annuity just doesn't do a good enough job at balancing longevity risk with legacy goals.
Similarly, for most immediate annuities, payments are fixed for life - or fixed for life with only inflation adjustments - eliminating any further upside opportunity. Notwithstanding the common fear of so many retirees about outliving their money, there is still something oddly disquieting for many retirees to acknowledge that once you annuitize your assets, there's no more upside potential. In other words, the transition to an immediate annuity is like saying "I guarantee this is the best it's ever gonna get." Maybe we have more of a goal and desire to leave ourselves the chance for something better than we acknowledge... even that also entails taking on a material risk that we don't even have enough to meet our original goals.
Maybe our problem with immediate annuities lies in our irrationalities. For instance, imagine a proposed retirement income solution for a client as follows: every paycheck for your working years, we're going to take a portion of your income, and allocate it directly to a future retirement annuity. You can't touch the money when it's paid, or at any point thereafter, even if you desperately need it for a dire emergency. Your retirement contribution to the future annuity is mandatory, and it will be a non-trivial portion of your paycheck (e.g., 6%). You can only start the annuity payments when the annuity company says you have reached a reasonable retirement age. If you're married, the annuity payments will be made on a survivorship basis, but if you pass away without a spouse - or are the 2nd to die of the couple - no future payments are made. All of your remaining savings in the retirement annuity are gone. If you're single, you can save (and will, since it's mandatory!) in the retirement annuity for 40 years but if you pass away right before retirement, all of the money is gone and you can't bequeath any of it; the annuity company keeps it.
I suspect if we proposed the above as a solution to retirement, the overwhelming majority of clients would be in an uproar. We're taking away people's opportunity to invest. We're preventing them from leaving legacies for their children. We're not allowing them to have access to their own money. We're forcing them to save in an illiquid investment vehicle they can't use for their needs and have no choice in the matter. Yet when we call it what it is - Social Security retirement benefits - we view the system as a fundamental pillar of retirement income. Odd how quickly our views can change depending on how the information is presented to us, isn't it?
And of course, this isn't our only irrationality in this regard. We have a strong desire to maintain liquidity - a common criticism of the immediate annuity - yet the reality is that most of our liquid funds sit idle for years and decades on end. We insist that choice is good and that we want to be the masters of our own destiny, yet the so-called "Paradox of Choice" reveals that we more often we are actually irrationally paralyzed by having lots of choices, rather than empowered. Similarly, when I suggested a mandatory retirement annuity savings system, many of you probably recoiled; yet when I pointed out that I was simply talking about Social Security retirement benefits, suddenly the idea didn't seem quite as bad. How are we supposed to deal with all this irrationality, where the manner in which the question is framed and the choice is presented has such an overwhelming impact on our views about it?
I'm not certain which of these factors is the driving force about why more clients aren't interested in immediate annuities. Perhaps it's some blend of all of these, including a more complex and nuanced set of goals than just "make sure I don't outlive my money" sprinkled in with some general lack of education (and "mis-"education) about the features and benefits of immediate annuities, and further complicated by all the irrationalities that color the lenses we use to view the problem and its solutions.
Nonetheless, the problem remains apparent: for all that's professed about the ideal nature of the immediate annuity as a solution to the retirement income problem, most people really don't seem to actually want to put their money there. There must be something else factoring into the equation in the client's mind, and the minds of the general public.
So what do you think? Why aren't immediate annuities more popular as a solution to the risk of longevity and outliving your money? What's "getting in the way" of the adoption of immediate annuities as a widespread solution to the retirement income problem?
True, by the time you layer on a number of guarantees, you end out with an annuity payment stream that is not substantively different than a "safe withdrawal rate" distribution level that generates comparable cash flows while maintaining access to all the assets.
But on the other hand, safe withdrawal rates are built for finite time periods. That research actually assumes you deplete the assets at the end of the (typically-30-year) time horizon. By contrast, the annuity pays "forever".
So in essence, the payment streams are comparable... except you can still outlive the portfolio, and you can't outlive the annuity.
So if we don't buy annuities, does that mean we're not really that worried about outliving our money after all? Or is there something else going on here?
However, I can't help but think that lower commissions could also play a significant part. That is, since SPIAs typically pay lower commissions than other products, advisors are less motivated to explain / recommend them to their clients.
Interesting perspective here. I think most people are critical of commissions in annuities being too high, but you make a notable point here that the relatively "low" commission associated with SPIAs actually represents a business challenge for many firms. It is a disincentive to present the option, given the long-term business implications for the "typical" AUM-style firm.
That aside, though, I still think this seems to be a significant challenge, even for those who DO use SPIAs as a primary part of their product offering to clients. Of course, advisors who don't offer SPIAs aren't likely to implement many, but those who do offer SPIAs don't seem to be very successful in implementing them all that much more in practice, either.
A fair point that products like this have an embedded cost. But on the other hand, I don't see clients saying "You know, I really like this annuity, I just wish it was 10% cheaper and then I'd be buying it."
In other words, notwithstanding some of the costs embedded, I'm not very convinced this is a cost issue (alone).
"For instance, imagine a proposed retirement income solution for a client as follows: every paycheck for your working years, we're going to take a portion of your income, and allocate it directly to a future retirement annuity. You can't touch the money when it's paid, or at any point thereafter, even if you desperately need it for a dire emergency. Your retirement contribution to the future annuity is mandatory, and it will be a non-trivial portion of your paycheck (e.g., 6%). You can only start the annuity payments when the annuity company says you have reached a reasonable retirement age. If you're married, the annuity payments will be made on a survivorship basis, but if you pass away without a spouse - or are the 2nd to die of the couple - no future payments are made. All of your remaining savings in the retirement annuity are gone. If you're single, you can save (and will, since it's mandatory!) in the retirement annuity for 40 years but if you pass away right before retirement, all of the money is gone and you can't bequeath any of it; the annuity company keeps it."