money in a tin


Public Perplexed About Annuities

Sales of annuities are slow, because most retirees simply don’t know how to assess their value, new research concludes.

Many of the nation’s top retirement experts agree that annuities are the best solution for retirees struggling with the best way to invest and spend a lifetime of savings.

Annuities have a singular benefit: they guarantee monthly income, no matter how long the retiree lives – something a savings account can’t always do. This constant, pre-determined stream of income has the added advantage of preventing financial mistakes as the elderly lose cognitive capacity, according to Harvard economist David Laibson. Smart Money magazine has dubbed annuities “dementia insurance.”

Yet sales of fixed and variable annuities have been largely flat over the past decade. This “annuity puzzle” has befuddled the academy for years.

Research by the Financial Literacy Center, a joint effort by George Washington University, the Wharton School, and the Rand Corporation, concluded that most people avoid annuities – they “stick to the status quo” – because they don’t understand how they work.

“How can they make these decisions if they don’t understand what a good decision is?” said a Rand senior economist and one of the paper’s co-authors, Arie Kapteyn. “We have to do something about the fact that people have to make these decisions” about managing their retirement wealth.

Social Security benefits are the most common annuity, so one would think they would be easiest for most people to understand. To test this, the Financial Literacy Center asked research participants two questions about their Social Security benefits: a) How much are you willing to pay in cash to get an additional $100 per month in monthly benefits for the rest of your life and b) How much cash would we have to pay you to give up $100 per month in benefits?

Kapteyn said that if the research subjects understood how annuities worked, their answers should’ve been roughly equal. Instead, individual respondents’ estimates of the annuity’s value to them varied wildly and inexplicably, from $17,500 to $200,000.

Further, those who were willing to pay next to nothing for an increase in their monthly benefits asked for enormous sums of money to compensate for a $100 decline in their monthly benefits. There was even a negative correlation: the more money people needed in order to give up $100 per month, the less they were willing to pay for receiving the extra $100.

There’s other evidence of confusion out there. Time after time, people in experiments and in the real world choose cash – a “lump sum” pension – over annuities. One research paper examined the behavior of retiring Oregon public employees. They had a choice between taking an annuity for their entire pension or taking a partial monthly annuity and a partial lump sum. They tended to choose the partial lump sums, even though the present dollar value of the annuity they gave up was higher.

Retirees also avoid annuities, even though figuring out how much retirement savings to spend every year is more complex.

Paradoxically, some employees choose annuities over cash. The vast majority of IBM employees picked the annuity when given the option of taking their pensions as an annuity, lump sum, or combination of the two.

Lump sums, annuities, spending down retirement savings – Squared Away invites readers to explain how they make this critical decision.

To read a classic research paper showing that annuities may be the best route for many retirees, click here.

Full disclosure: Some research papers cited in this post were funded by grants from the U.S. Social Security Administration (SSA) through the Retirement Research Consortium, which also funds this blog. The opinions and conclusions expressed are solely those of the blog’s author and do not represent the opinions or policy of SSA or any agency of the federal government.

8 Responses to Public Perplexed About Annuities

  1. Kelley Long says:

    A great topic and a great post, thanks for starting the conversation!

    We can also thank popular personal finance “personalities” for giving annuities a bad name. The classic reason industry professionals give for rejecting annuities is the high fees, as calculated as a percentage of the total balance, which makes sense. But I definitely think that annuities make sense for certain retirees, especially those who have not adequately saved for retirement.

    Psychologically, I think the reason that people prefer the lump sum even though they would receive less over time (assuming they live to their full life expectancy) is that they want the feeling of control over ALL the money, not just as it comes in. I mean, what if something terrible happens and you need a big chunk of money? That’s why I think people choose that option.

    Plus, most people can really only turn to the person SELLING the annuity for answers, and this automatically casts a shadow of suspicion on the answers.

    Thanks again for the post — lots of food for thought!

  2. Sales, unless it is forced, should only be after comprehension of alternatives. However, current “educational” efforts around annuities are very old-fashioned, sales-driven, and ignore the latest research in the brain, cognition and learning theory and practice.

    We are trying to change this at our start-up firm – Stay tuned.

  3. Larry Littlefield says:

    Two words: Counterparty risk.

    The executives at the insurance companies that offer annuities have to decide how much money they need to set aside to pay future benefits, and how much can go to shareholders or executive pay, based on a bunch of assumptions. There is an obvious self interest aspect to their decisions.

    Just like public employee unions and politicians deciding how much needs to be contributed to fund existing pensions, and how much can go to tax cuts and retroactive pension enhancements in exchange for political support. We know how that one turned out.

    In each case only those actuaries willing to play ball will be hired.

    It’s hard to trust anyone in the era of Generation Greed. Even mutual insurance companies can de-mutualize to get big executive paydays, after spreading some campaign cash around state legislatures. The way New York’s Blue Cross Blue Shield did.

    Buy an annuity, and your eggs are in one basket, which in some cases will turn out to be rotten. I liked the idea of deferring collecting Social Security better.

  4. J Mills says:

    You did not point out that fixed annuities are generally not indexed for inflation. If this were to happen I think the pattern would change. Also, what I have read says that you should use annuities to fund fixed expenses but keep other assets flexible for the remainder.

  5. Maynard G Keynes says:

    You’d have to be a fool to buy an annuity today. They are based on the long-term bond rates, which the Fed is artificially suppressing. Today’s annuities are a trap for the elderly, and they know it. And yes, I would be thrilled to sell you my stream of Social Security payments in exchange for the lump sum, equivalent based on Bernanke’s rates. I’d put that big pile of money in TIPS and sleep like a baby.

  6. John Gilmartin says:

    I’m sorry this is so long winded. I retired from the UN a few years ago, and we had the choice of taking a ‘full’ pension, or a partial lump sum and partial pension. The great majority of folks opted for the partial lump sum, and the reduced pension amount. We are lucky to have an inflation adjusted pension system, and essentially full vesting within a few months of joining. You can also opt on retirement to instead take a ‘full withdrawl’ which would be the full amount contributed into your pension over your working time with the UN. The only folks taking this option were usually already seriously ill and not expecting to live long.

    I choose the full pension by going to a website managed by the U.S. government which offers to sell annuities to retiring U.S. civil servants. You plug in the amount of the annuity payment you want to receive monthly, and the website tells you the amount of your savings needed to buy that annuity.

    I quickly learned that my guaranteed, inflation adjusted full pension from the UN was worth far more than I would have to invest if I were buying a lifetime immediate inflation adjusted annuity. I checked the figures against some other annuity selling websites to be sure I had the right notion.

    I did the same thing deciding when to take Social Security payments. Again, I discovered that my Social Security payment had the value of a large annuity purchase, if I simply had to go out into the annuity market, and buy the equivalent product guaranteeing me a lifetime inflation protected stream of payments. UN employees who are U.S. citizens continue paying into Social Security, Medicare and U.S. income taxes during their UN employment.

    Since it’s impossible to buy a one time annuity for lifetime health insurance in the USA, I tried to guesstimate what such an annuity might cost. My UN health insurance was costing me and the UN combined about $25,000 yearly for a family policy with NY Blue Cross (or Van Breda the international health insurance carrier). To purchase an annuity that guaranteed me an annual stream of $25,000 with inflation adjusting would cost me over $1 million at age 62. I had actually contributed much less than that in both the UN health insurance plan and in my lifetime of payments into Medicare. So, what I concluded is that my Medicare payments (and UN health care payments) have been/are extremely beneficial financially. I could never afford to buy such levels of coverage in retirement. I don’t think many people have tried to estimate the actual cost value of these insurance coverages, they take it for granted because they have never had to try to buy this level of health insurance.

    I think the government needs to do a much better job of explaining what we the tax payers are buying with our Social Security and Medicare payments, and how much these will benefit us in the future. My father’s last two-week stay in hospital was billed at $63,000. The bill nearly killed my mother, until she realized Medicare and her insurance covered it.

    I don’t trust the insurance industry to sell me an annuity at a fair price because the products are not regulated and the number of types of annuities are so varied and difficult to understand. Many of the annuity sellers have left the business, and most companies hide their AM Best ratings as well as an objective guide to these firms longterm financial strength. I’ve read that annuity insurance sales commissions are the highest in the insurance sales field, such that these products attract a type of sales pressure prone to unfair conflicts.

    Instead of promoting the use of annuities or better marketing of annuities, I would recommend looking closely at the Danish private pension business. Most Danes open private pension accounts when they are very young. They and their employers contribute to this young person’s private pension account from their early 20’s until retirement. These companies are well regulated and the pension holder always knows how much he and his/her employer have contributed. These funds are vested immediately, so when/if the youngster quits one company he/she does not loose their most valuable early year savings.

    These well-managed private pension firms, and the Danish system of covered mortgage bonds are two of the reasons the Danes are so financially secure and sensible in a generally stressed out world.

  7. Nick says:

    Pretty obvious from the comments that annuities are not popular. My question is this, what else would someone do with the money? You keep saying that I’m putting all my eggs in one basket but isn’t that what people have been doing their entire working lives? They are told they are “diversified” but somehow still lost half their retirement value in 2008, not many baskets there. Not to mention the fact that their money has been locked away in 401ks and other similar vehicles.

    As I write this out I realize that the downfalls that are being pointed out about annuities are exactly what people are used to when it comes to their money.

  8. We all know that there are advantages and disadvantages when investing in annuities. Always make sure to learn about the types of annuities that suit your lifestyle. Better to seek a financial adviser who doesn’t have a conflict of interest.