Economists and actuaries love them. Advisers are leery of them. And investors seem to avoid them whenever possible. What products could so clearly divide the world of professional experts from the everyday domain of investors? The answer is income annuities--and the issue is whether investors should hold a longevity-protected stream of income as part of their savings and investment program in retirement.
Income annuities are the polar opposite of their sometimes notorious cousins, variable annuities, which are used principally for their tax advantages during the accumulation period of saving. An income annuity is largely directed at the withdrawal or spending phase of retirement. With an income annuity, an investor transfers a lump sum to an insurer, who in turn promises to provide income that will last as long as the investor or his survivor lives (based on the claims-paying ability of the insurer). The income can be fixed in nominal terms, it can vary with investment performance or--in the latest innovation--it can be inflation-adjusted. But the key feature is an income stream that will continue until death, offering important protection against the risk of living too long.
THE CONTROVERSY
Everyone agrees that longevity risk--the chance of living a long life and outlasting your financial resources--is a critical factor that investors face as they transition from work to retirement. There are two ways to manage this risk. One is to accumulate a large pool of assets, thereby "self-insuring" longevity risk. The one drawback is you cannot know with certainty how long you'll live. If your life is shorter than expected, you've left a large pool of capital to your heirs and failed to benefit from the assets while you were alive. If your life is exceptionally long, it'll often be difficult to accumulate sufficient resources to insure against such a low-probability event.
The other strategy is to pool longevity risk with others--for example, through an income annuity. Actuaries can predict life expectancies for groups of individuals with stunning precision. In a pooling arrangement, benefits pass from low-risk individuals (those who live a short life) to high-risk individuals (those who live a long life). And there are enormous efficiency gains to be had from pooling risks. The need for longevity-protected income seems even more pressing with companies moving away from traditional pension plans that provide income for life.
So why don't more investors take advantage of income annuities?
LET'S BE REALISTIC
From a purely rational perspective, there are several distinct problems with income annuities. One is complexity. With the large number of insurance options available on these contracts and the murky jargon that surrounds them, many clients simply throw in the towel before fully considering the benefits of an income annuity program.
Another issue is transparency. Income annuities are a contractual obligation of the insurer, and so insurers do not typically disclose the types of assets backing the contract. There's no marketplace where product features and costs are compared in a systematic way.
A third problem is costs. How much compensation is the insurer receiving for a given annuity? It's difficult for advisers and clients to understand what they're paying for. And then there's a pricing risk that arises due to what economists call "adverse selection." Income annuities tend to attract a healthier, longer-lived population than the average group of retirees. That means payments are generally lower on average than they would usually be. As a result, less-healthy individuals feel annuities are too expensive and decline to buy them.
QUICK TO JUDGE
There are also several behavioral elements that undermine the use of annuities. First is the overwhelming tendency of individuals to overestimate their chances of dying young and to underestimate their chances of living a long life. Ask investors in focus groups about committing, say, $100,000 to an income annuity, and most will talk about the risk of losing their money if they die young.
How the annuity decision is framed counts, too. In the case of annuity payouts from defined benefit plans, the question to participants is typically provided as an all-or-nothing choice: Do you want 100% annuity income for life, or would you like 100% as a lump sum? This is doubly confounding because the annuity amount is stated in monthly terms, such as "$1,000 of income per month for life," while the lump sum amount is stated in the hundreds of thousands of dollars. Participants in retirement plans are rarely given the option of combining the two choices.
In the adviser market, the framing of the annuity decision is usually centered on a dollar value being invested. For example: "If you commit $200,000 to an income annuity, your income will be $16,000 a year." Inevitably, investors worry about forfeiting several hundred thousand dollars if they die early. But if that investor has a $2 million portfolio or $2 million in net worth, a more effective framing might focus on what percentage of that is being annuitized: "Committing 10% of your assets to an income annuity generates $16,000 a year."
Another way of reframing the annuity decision is to consider dollar-cost averaging. In our example, rather than committing 10% of the portfolio immediately to annuities, the adviser can divide the program into several smaller commitments over time. This seems like a particularly sensible strategy, given that when purchasing an annuity, investors are--in effect--locking in long-term interest rates on the date of purchase.
THE MAIN CHALLENGE
But the real problem with income annuities is a lack of a widely accepted framework for deciding on an appropriate level of longevity insurance in an investor's retirement program. For many investors, Social Security may be all of the government-guaranteed longevity insurance they need. For others, additional annuitization may be necessary. But exactly how much is a largely unsettled question.
This is the fundamental challenge for proponents of income annuities. Not until we have simple rules of thumb based on a broader theory will annuities become a more important part of individual portfolios. Meanwhile, advisers have a tough task ahead--figuring out what level of annuitization makes sense for a client, especially in light of the longevity risks we all face in retirement.
Stephen P. Utkus is director of the Vanguard Center for Retirement Research, which analyzes developments in the U.S. retirement savings and benefits system on behalf of plan sponsors, consultants and policy makers. For more info, visit www.vanguardretirementresearch.com or call (800) 523-5779.
