Annuities Fulfill Their Core Purpose Beautifully

November 16th, 2009

Fish swim, birds fly, dogs bark, cats meow, politicians spend. Everything has a core purpose. That is the thing it was created to do, the thing it does better than anything else, its singular attribute.

Every financial instrument has a core purpose. Corporations attract capital by limiting liability. Stocks promote growth of capital by providing a residual claim on corporate earnings. Bonds attract loanable funds by giving lenders a senior claim on assets.

As for annuities – they provide retirement income that is guaranteed to last a lifetime. This is unique; no other financial instrument does it. Of course, annuities are not limited to a single function, but guaranteed lifelong income is their raison d’être.

Annuity Critics

Why bother to emphasize such a simple and obvious point?  Because commentators up and down the Internet studiously ignore it. Usually they expound on the shortcomings of annuities compared to their favorite investment. Occasionally, for variety, the procedure is reversed – the writer will rave about annuities without mentioning their core purpose.

The fact that some commentators make cogent arguments is beside the point. A financial instrument cannot be judged without evaluating how well it performs its core purpose.

Different Strokes for Different Folks

People differ in age, wealth, income and occupation. They differ in their degree of time preference; some people are present-oriented and heavily discount the future, while others are deeply committed to planning for the future. They differ in their attitudes toward risk; some people are highly risk-averse, other much less so.

These differences are matters of personal taste and circumstances, not logic or morality. The objective of finance and investment theory is to make everybody as happy as possible, not to force one “optimal” set of investments down everybody’s throat.

Each financial instrument has evolved with a core purpose that suits it for particular people under particular conditions. Financial advice should match up the particular instrument with the right people and the right conditions.

Stocks are for people who want growth. Bonds are for people who want income. And annuities are for people who want security. There is overlap among these financial instruments and their core purposes, but that doesn’t alter the fundamental logic.

That fundamental logic – the economic theory of finance – says that annuities fulfill a basic need. Annuities have occupied a comfortable niche in this theory for a couple centuries.

Annuities Abroad

There are two ways of proving a case – with logic or with facts. The factual case for annuities is made abroad.

Here in the U.S., “retirement income” is synonymous with “Social Security.” In 1924, Chile became one of the first countries to install a government-run, Social Security-type system. By the 1970s, that system was technically insolvent, relying on infusions from general revenue. Accordingly, the federal system was replaced with a mandatory private one. Workers contribute at least 10% of earnings into personal accounts that are invested in stocks, commercial bonds or government bonds. Upon retirement, workers can either use their accumulated funds to purchase a private annuity or receive programmed withdrawals geared to their actuarial life expectancy.

After 15 years of operation, aggregate personal accounts totaled $23 billion, equal to about 40% of Chilean GNP. The average yield at that point was 14%. Chile became one of the world’s most avid issuers of immediate life annuities.

Do annuities only work in Chile? No, it seems that Latin American neighbors Peru, Argentina and Colombia emulated Chile by adopting their own private systems. Do annuities only work in the Southern Hemisphere?

No, the United Kingdom is in the Northern Hemisphere. In the late 1980s, British were allowed to leave the state-run social insurance system and instead develop private accounts. At first, annuitization of private account balances no later than age 75 was mandatory. Changes in 2001 and 2006 relaxed the mandatory element somewhat but retained the privatized structure, along with a strong incentive to annuitize. Once again, a bankrupt public system was replaced with a private, annuities-based one.

Let Annuities Be Annuities

Annuity critics in the U.S. claim that annuities only make sense for the wealthy, not the hoi polloi. Yet these same people complain bitterly that the patrons of 403(b) tax-sheltered annuity accounts have the temerity to favor annuities over mutual funds for their accounts. Presumably, these annuityholders are wealthy teachers, police, firefighters and employees of state and local governments and 501(c)(3) non-profit companies.

The performance of annuities in the U.S. market is all the more impressive given the overhang of the Social Security system. Not only does this preempt money that would otherwise be directed to annuities, it also creates an adverse selection problem for insurance companies. When allowed to fulfill their core purpose, annuities work beautifully. Instead of berating annuities for the wrong reasons, critics should help create the environment in which annuities can thrive.

Category: Annuities, Retirement Planning | Tags: , ,

One Response

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