Annuities have been around forever. Anybody with any experience in investments is familiar with them. They’re issued by insurance companies, the epitome of financial soundness. Fixed annuities are considered conservative investments. And, to top it all off, their signature feature and unique claim to fame is the ability to provide guaranteed income for life.
Yet, according to one reliable source, “the majority of modern annuity customers use annuities only to accumulate funds and to make lump-sum withdrawals without using the guaranteed-income-for-life feature.” Another source notes that “voluntary annuitization of income is rare.” As a source of income in retirement, private annuity payments have been estimated to comprise less than 2% of the total. Academic researchers find this so surprising that they have come to call it the “annuity puzzle.”
What’s going on?
Annuitization Without Annuities
The biggest piece of the “annuity puzzle” is filled in by the Social Security program. In the U.S., as in most other developed countries throughout the world, workers “contribute” large sums from their paychecks to a program of “social insurance,” ostensibly designed to provide lifetime income for their retirement years. In fact, these “contributions” are actually tax collections that are paid out to current retirees instead of being invested to grow and provide future income to “contributors.”
It is tempting to conclude that the Social Security program (specifically, what used to be called its “old age and survivors’” component) has nothing to do with private retirement plans. Social Security payouts are given in the form of lifetime level payments, however; this makes them partly analogous to private life annuities.
The fact that so much of workers’ wealth is allocated to a program that promises annuity-like payments at retirement is highly significant. Academic studies say that over 50% of all current retirement wealth is “pre-annuitized.” Most of this is tied to Social Security. This seems to be the major explanatory factor behind the unwillingness of Americans (and others) to annuitize their remaining wealth. In effect, the government has already “annuitized” the majority of their retirement wealth.
Reasonably enough, most people decline to commit even more of their retirement wealth to a relatively-illiquid income-producing asset. Indeed, a substantial fraction of prospective retirees have little left over for private retirement savings after Social Security taxes are deducted from their paycheck. When retirement rolls around, they have little accumulated private wealth to annuitize.
Another piece of the puzzle is supplied by the incidence of defined-benefit pensions, whose payment structure also mimics that of an annuity. For many decades, pensions were the leading form of company retirement plan.
Pension income forms the other major component of “pre-annuitized” wealth. Although some pensions offer the option of lump-sum withdrawal at retirement, the more usual arrangement is a pension payout. This requires the pensioner to bear a certain amount of company-specific default risk.
Academic studies also cite the “actuarial unfairness” and “high cost” of private annuities as rationale for public indifference. “Actuarial unfairness” refers to the fact that the insurance-company payout is less than the discounted present value of the annuity purchase price valued over the expected lifetime of the purchaser. The studies usually fail to probe the reason for this.
Most private annuities are purchased by relatively high-income individuals, who have money left over to devote to private retirement saving after paying Social Security taxes. Statistically, high-income individuals also live longer, on average. The rate of return on an annuity (or on Social Security taxes) increases with longevity. In a world without Social Security, insurance companies could afford an “actuarially fair” payout because some middle- and low-income people would also purchase life annuities. Overpayments to long-lived people would be counterbalanced by profits earned on short-lived people. Competition among annuity issuers would indeed produce this “actuarially fair” outcome.
The presence of Social Security means that insurance companies are plagued by “adverse selection;” it is mostly the less-profitable longer-lived people who can afford to buy annuities. Consequently, the purchase price of life annuities rises or, equivalently, their payout falls.
The irony of this situation is that the Social Security program offers rates of return that are much lower than those from private annuities; e.g., much more “actuarially unfair.” Thus, replacement of Social Security by a program of private annuities would not only lift a crushing financial burden from the federal government but also make annuitants better off.
Longevity Risk Pooling
Annuities were created to address the issue of “longevity risk” – the danger of outliving one’s income. In a non-artificial setting – untainted by the distortions induced by Social Security – insurance could handle the problem. The fundamental technique employed by insurance companies is the pooling of risk – companies bear the risk they lift from policyholders by relying on the “law of large numbers.” Some people will outlive their life expectancy, others will die early, and the aggregate result will balance out for large numbers of individuals.
When insurance companies cannot effectively pool risk, their products are less attractive. Individuals and households then improvise their own solutions. Marriage can be viewed as a primitive form of risk pooling; the survivor inherits the assets of the first to die, thus augmenting their individual wealth and reducing their own longevity risk. A more systematic approach is the formation of investment pools for the purpose of reducing longevity risk. This option is more attractive for single individuals who cannot pool via marriage. These non-corporate longevity-risk pools are still in their formative stages.
The Future of Annuitization
Three factors suggest that conventional annuitization may experience an upswing in the not-too-distant future. First, the normal retirement age for Social Security has increased, thereby reducing the portion of wealth committed to forced pre-annuitization. This makes private annuities more attractive. Second, defined contribution plans have supplanted defined-benefit pensions as the private retirement plan of choice. Defined-contribution plans rarely require annuitization. Thus, private annuities again become more attractive. Third, the recent financial meltdown has heightened public sensitivity toward the portfolio risk borne by holders of equities and even fixed-income securities. This probably represents an increase in average risk-aversion. Since annuitization increases as risk aversion increases, this also will tend to drive people toward private annuities.Category: Annuities, Economic Analysis, Fixed Annuities, Retirement Planning, Risk | Tags: Annuities, Annuity Benefits, Annuity Blog, Economic Analysis, Insurance, Retirement Investing