THE ANNUITY OPPORTUNITY

The world’s most reviled financial product may save your retirement

Most people hate annuities. Hardly anyone buys them (pdf) and they’ve become synonymous with bad financial advice. But economists—who are also people—love annuities and can’t understand why others don’t. The number crunchers have even dubbed this vexing fact “the annuity puzzle,” and expend a lot of energy speaking at conferences and writing journal papers about how to solve it.

And yet, despite their unpopularity, annuities endure. Ancient Romans (pdf) used annuity contracts. Jane Austen wrote about them. Benjamin Franklin put them in his will.

One reason for the disconnect is that when economists talk about annuities, they mean a simple financial product where buyers hand over a large chunk of their money to an insurance company, which in return pays them an agreed income every year until they die. Live a long life, and the annuity pays out more than the buyer puts in. Die early, and the annuity provider pockets the profits. Pooled across many buyers, the risks are reduced for the insurance company and buyers are given comfort that they won’t outlive their savings.

But why not just manage your retirement savings yourself? Invest unwisely or spend too freely, and the money might run out. To be prudent, it’s best to budget for the possibility of living beyond your life expectancy, reducing the amount you spend in your golden years. The odds are that you’ll have less money to spend than an annuity would get you.

 It’s generally good to stay away from financial products where it’s unclear what you’re buying and how much you’re paying. The thing is, the market is full of complex annuities that do other things, like tie up your money while you’re still saving, link payouts to complicated formulas few understand, and levy a fortune in fees. These sorts of products are what most people think of when they think of an annuity. They should hate them.

It’s generally good to stay away from financial products where it’s unclear what you’re buying and how much you’re paying. A recent study of financial advisor misconduct found that the largest share of complaints involved annuities. MetLife was hit with a $25 million fine last month for misleading annuity investors.

Roger Ferguson, a former Federal Reserve governor and current CEO of Teachers Insurance and Annuity Association (TIAA, formerly known as TIAA-CREF), hopes to redeem annuities. TIAA is a non-profit that offers financial services mainly to teachers and other non-profit workers. The organization’s status and clientele has made it a thought leader on retirement products intended to serve the public good. When Ferguson says he thinks annuities are Americans’ best shot at a secure retirement, it is worth hearing him out.

Shifting the burden

Roger Ferguson, CEO of TIAA.
Roger Ferguson, CEO of TIAA. (Reuters/Chip East)

I asked Ferguson if he thinks the shift from defined benefit pensions (where employers pay a portion of a worker’s final salary for life after they retirement) to defined contribution plans (a 401(k), IRA, 403(b), or similar accounts in which individuals shoulder all of the investment risk) has made retirees worse off. He stresses that many things have changed to make Americans feel less financially secure, but the problem isn’t self-directed plans—it’s lousy plans that get people focused on the wrong goal. “The rise of 401(k) got people thinking about asset accumulation instead of lifetime income,” he says.

He thinks this is a misguided approach. After all, defined benefit plans focus on income; changing the plan structure doesn’t change the goal. In a world where defined benefit plans are increasingly rare (pdf), we need better defined contribution alternatives. These need to solve two problems: low saving rates and forcing individuals to shoulder too much risk. To increase saving, Ferguson would like to see more of the standard solutions: easier access to plans, automatically enrolling people in them, mechanically increasing people’s saving rate as they earn more, expanding low-fee investment options, and promoting objective advice.

 Most people are taught to save a big chunk of money, but aren’t given guidance on what to do with it when they retire. Things get more controversial when he delves into what people should do after they retire. He thinks pension accounts should include an annuity option that’s easy to enact. But not for all of a retiree’s savings—that would mean that the money was tied up with an insurance company, unavailable for big, unforeseen costs, like health care. Ferguson stresses a more nuanced approach. He wants retirees to annuitize a portion of their wealth, enough to cover basic life expenses like food, housing, and transport.

Ferguson says about 40% of TIAA customers annuitize some of their savings at retirement, compared with 6% of the rest of the population. He credits the high take-up rates with the fact TIAA offers annuities as an investment option in their defined contribution plans. Their advisors also preach the benefits of annuities early. Ferguson says the problem is most people are taught to save a big chunk of money—”to think of a big number,” he says—but nobody gives them guidance on what to do with it when they retire.

The law of large numbers

At current interest rates, dividing your wealth by 21 gives you a rough estimate of how much inflation-indexed annual income you can get with an annuity after you retire. This is, roughly, the present discounted value of savings spread over the average 65 year-old’s life expectancy. So suppose you have $200,000 saved, which would put you in the top 30% of Americans between the ages of 60 and 65. That may sound like a lot, but it only gets you an income of $9,500 per year.

If instead you keep the money and invest it yourself, it would be wise to plan for it to last beyond your life expectancy, to ensure the money doesn’t run out before you die. That means that, perhaps, you’d only be able to spend $7,000 to $8,000 a year (or less, if you don’t play the market right). But the difference in this scenario is that you don’t part with a big chunk of your savings upfront, which delays the realization that you may have not saved enough or you aren’t as shrewd an investor as you think.

 “Unfortunately, people have negative opinions, so demand is low and the supply of good annuities is not as high as it should be.” This may explain why even the plain-vanilla annuities beloved of economists haven’t proved very popular among the public. Partial annuitization was required in the UK in some form for almost 100 years, but this was repealed last year. A large share of people with guaranteed lifetime incomes from defined benefit plans choose instead to withdraw it all in one lump sum (pdf) when given the chance.

Annuities can be expensive compared with keeping your money in index funds. And many retirees have so little money saved that annuitization isn’t worth it. If you only want to annuitize 25% of your $200,000 in savings, that’s worth only $2,300 a year in income, which may not be worth it given the fees.

TIAA is a non-profit and can therefore afford to offer cheap annuities to its members. But Ferguson believes that this shouldn’t stop others from giving retirees better deals. “It’s a chicken and egg problem: Unfortunately, people have negative opinions, so demand is low and the supply of good annuities is not as high as it should be,” he says. “We have to break into that cycle.”

That may come from a policy push, education drive, or some combination of the two. New standards for financial advisors from the US Department of Labor is expected to shrink the annuity market even more. It is hoped that this will drive out the bad annuities that give the industry a bad name and make way for better, simpler alternatives.

Ferguson hopes one day people can distinguish a good annuity from a bad one in the same way investors—some of them, anyway—eschew expensive mutual funds in favor of low-cost index trackers. In that world, buying an annuity, at least to cover the basic expenses that arise during retirement, will become a routine, uncontroversial decision.

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