Among economists, it’s sometimes known as the “annuities puzzle”: Why don’t people buy annuities as frequently as one might expect?
I think that the puzzle is why economists insist that annuities are a terrific idea.
The idea of an annuity is this:
1. Suppose that at age 65, you have $500 K and you retire.
2. If you are going to live to age 75, you can afford to spend a lot of money every year. But if you are going to live to be 100, you can afford much less.
3. If you trade your $500 K for an annuity, you can then spend the amount appropriate for an average life expectancy, regardless of how long you actually live. If you don’t live very long, the company that sells you the annuity wins. If you live longer than the average person, then the company loses.
Economists think that old people who do not annuitize their wealth are dumb. I decided a long time ago that it is the economists who are dumb.
Old people face many risks other than the risk of living longer than average. Many risks give rise to needing to spend a lot of money at once. You might develop an illness that is treatable but very expensive to deal with. You might find that you have grandchildren living in a different city, and while you are still relatively healthy you want to visit a lot or even pick up and move there.
The risk of excess longevity is one that you can transfer to your children. That is, you might plan to leave $250 K to your children if you die at age 85, but you leave them nothing if you die at age 95.
So why not put some of your money into an annuity (to mitigate longevity risk) and keep some for emergencies/opportunities?
Defined benefit pensions are basically annuities, and people seem to like them.
I suspect counterparty risk is a significant factor in this decision.
Owning a residence is like having a pension or annuity, in that the imputed rent (ok, net taxes, insurance, and maintenance), is the dividend, and housing is a huge expense and big worry. Also, unlike some annuity payments, the net imputed rent is not taxed as ‘income’. And, not only does this dividend continue indefinitely as long as you live, it is does not terminate on death at all, and you can give the asset to your kids as an inheritance. The homeownership rate for 80 year-olds is 81%. For 84 year-olds it is 92%.
And, of course, so so is Social Security an annuity. So between owning a home and receiving one or two SS checks a month, Americans have covered some of this “short” which economists believe exists.
Moreover, there may be better –cheaper, more flexible — ways than bells and whistle annuities to add some additional longevity protection: QLACs (qualified longevity annuity contracts). These can even be owned in an IRA. I think the trend could be for these to become more and more plain vanilla and liquid enough to allow some risk management.
Do these economist also understand how high the commissions on many annuities can get, and how calling up lonely old people and getting them to sign up for these things is a giant industry? I briefly worked for a company that paid 15% commissions up front for selling annuities to grandmas. So on 500k you are losing 75k just to the salesmen (not to mention what my company took home).
I get it there are probably some good annuities out there but just as its hard for many people to understand basic finance its even harder for grandma.
My tax lawyer said the same thing, annuities are too expensive.
As someone who actually worked for a major Insurance Company that sold annuities, I can tell you that our annuity commissions were paid by the company, not the purchaser. If a client put $500K into an annuity, as per the example given, their $500K was invested in their annuity, and the Insurance Company paid the commission. This is one of many common complaints about annuities that are just flat incorrect. That is not to say that there aren’t annuity providers who do take the commission from the premium, but they are almost non-existent today.
One way or another, the commission comes from the purchaser. No way around it.
Your answer makes no sense. The client started with 500K and the salesman walked away with 75K.
It doesn’t matter how you obfuscate the paper trail, in the end that cost is being born by the client.
I also worked in financial services for a time and the #1 law is that the higher the commission, the worse the product.
https://www.youtube.com/watch?v=nJzo5TDfamk
Even Jesus didn’t make 75K worth of wine out of nowhere, he needed water! But please tell us more about how the insurance company managed to make 75K magically appear. Are you a wizard? Did you work with goblins? Be ye a hoodwinked muggle, expert troll, or did you really get the troll OWL in economic magic necessary to believe that robbing grandma is free?
Enter comments, stranger, but take heed
Of what awaits the sin of foolish greed
For those who take fees they only think they earn,
Have no fiduciary responsibility to avoid the burn
So if you seek beneath grandma’s floors
A treasure that was never yours,
Thief, you have been warned, beware
Of finding more legal treasures there.
This is reasonable about Economist here and I would add one more thing…People with $500K are also probably smart enough to understand the weaknesses of annuities. They know they probably ‘losing’ money and are paid less in most cases. The people less likely to buy one are also people not likely to retire with $500K.
You have more than once commented the surprise on Home Flippers and why they don’t have more of the market.
Probably the same reason why annuities don’t sell more:
1) Most home sellers lose 15 -20% of sale price to Home Flippers. Real estate agents are 5 – 6%.
2) Most buyers value home upgrades less then they would pay for it. I sold a house with landscaping that cost $4,000 and probably brought $1,000 back to me.
3) Most home sellers are not in a cash crunch so they can wait 60 days for final payment.
4) There are people that sell to flippers: Houses in terrible shape, people under cash crunch, maybe houses with very limited upgrades in an expensive neighborhood.
The landscaping was a year old and we had not planned to move in 12 months. Otherwise I would have not installed landscaping.
This seems like pretty strong evidence that Social Security benefits — a mandatory government annuity — are far too generous. If that weren’t so, then seniors would supplement Social Security by purchasing additional annuities from their savings. Apparently, the vast majority, if given the choice, would rather have less Social Security and keep the tax savings unannuitized.
Striving to better, oft we mar what’s well
-Shakespeare
Besides them being expensive, they are at a huge tax disadvantage compared to equities or real estate. They don’t get to step up their basis. You might also be paying income tax on them instead of cap gains.
Economists are right, not dumb. The purpose of an annuity–which I plan to invest in, being in the 1% (minimum net worth of $10M in the US) –is to avoid having to set up a spendthrift trust, which costs between $50k to $100k a year to fund (even I blanch at having to spend that much for a lawyer doing next to nothing, on top of the fees an index fund will charge). An annuity is a cheap way to do a spendthrift trust. A spendthrift trust is a trust administered by a lawyer to give to a rich person’s heirs in the event they are too immature to manage a lot of money lump sum (which is most of them). It’s a common problem that rich trust babies, unless monitored carefully, typically blow their lump sum inheritance in a few years. Using certain annuities having the measuring life in the beneficiary (a bit expensive but not unduly so, cheaper than a trust), you can avoid this problem of ‘shirtsleeves to shirtsleeves in three generations’. Read the excellent book “Fortune’s Children: The Fall of the House of Vanderbilt” by Arthur T. Vanderbilt (1988), which showed the richest man in the late 1800s (before JDR) ended up having such imbecile offspring that by the fourth generation, in 1973, not a single millionaire was present out of 120 offspring of the original Vanderbilt that met in a family reunion sponsored by Vanderbilt university. They had spent it all.
Annuities are a perfect investment for a significant number of older people. I have a 72 year old friend who has in investment portfolio of close to $1million. No wife kids or relatives he wants to leave money to.
He is afraid to spend any money because he thinks he is going to run out of it so he lives on $35,000 a year or so. If he would simply buy an immediate annuity with no survivorship rights he could get around $90,000 a year without the fear of running out of money.
I’ve looked at fixed annuities and they do not seem to be fairly priced, based on an expected present value calculation using current interest rates. I can think of at least two reasons why not. First, companies offering them need to make a profit. Second, there is an asymmetric information issue. Annuities would be most attractive to people with longer expected lifespans, that is, those in good health and with long-lived family histories. So returns have to be reduced accordingly. George Akerlof would probably have something to say about this.
Besides all the other annuity problems, there’s sovereign risk, which is coming to the fore in the developing election campaign. There are those who wish to spend like drunken sailors and pay for it by inflating the currency. One version of this is called “modern monetary theory”. Some other versions fall under the ineffably undefined rubric of “socialism”, which seems oh-so-fashionably among the young and foolish.
So even if buying an annuity might, in principle, hedge against living to 100, why would the agreed annual sum be worth much of anything by the time one reached 100? Keep in mind that the important question here is not about the number of megapixels on TV screens, nor any other such frivolous twaddle that some economists use to claim that well, inflation is really negligible because look at all that fancy new entertainment tech. But hedging against old age is firstly about basic living costs – housing, food, energy/electricity, medical copayments, etc. You can’t eat megapixels, and by age 100 you may not even perceive them effectively.
And if money (US$) is mentioned in a vintage movie or TV show, it seems convenient simply to tack an extra zero onto the amount to guess roughly at what the characters are talking about in practical, real, terms. That happened even without MMT and the like, and it only reinforces the idea that counting on a regular annuity as anything much of a hedge against extreme old age is simply ridiculous. By the time today’s 55yo or 60yo annuity purchaser reaches 100, will just a cup of Starbucks coffee also be $100? $500?
Yes inflation risk and I hear that the inflation adjusting annuities are too expensive.
Some of these counters are unpersuasive
‘Many risks give rise to needing to spend a lot of money at once. You might develop an illness that is treatable but very expensive to deal with.’
The likelihood of landing a treatable, but expensive illness that you could afford to treat with $500,000 and then afford to live off what was remaining is pretty small. Discovering that you have a large expense is a bad outcome for pretty much any investment decision that you make with a borderline amount of money.
The reason that hardly anyone buys them in the US seems fairly obvious to me, social security functions as an annuity already and covers the majority of citizens, doubling up would be fairly unnecessary.
The problem is that annuities are mispriced for solving this problem – ask a provider how much it would cost for a $50k/year annuity that starts paying at age 75 – theoretically this should be very cheap as it starts after your expected death…it is very expensive