Annuity Puzzle

Bemoaning the demise of the defined benefit plan is a popular past-time. People used to have it easy when it came to retirement planning. Get a gold watch, and live off of Social Security and the company pension. Live within your means as you had your whole life.

Today we have to figure out the income we need, how to structure an investment portfolio, and whether we can sleep at night with the inevitable ups and downs of the market. We have to do involved, careful calculations to determine the safe withdrawal rate.

But there is a simple way to effectively convert at least a portion of a portfolio into a guaranteed income stream: buy a single premium immediate pay annuity (SPIA). That is, give an insurance company a lump sum and they will pay you for as long as you live. The amount you are promised is greater than you can generate yourself by buying bonds because you are paid on the basis of group mortality rates. Essentially you win if you live longer than average, and the insurance company wins if you don't. This is a bit of a simplification. Actually you gain from the peace of mind a guaranteed income can provide.

The question is why retirees don't take greater advantage of these types of annuities. Why don't they convert the uncertainty of an investment portfolio into a guaranteed income stream upon retirement? In fact, this is called "The Annuity Puzzle" as explained by Richard H. Thaler. One reason, Thaler points out, is that those retirees who die younger lose out. But on the other hand, live too long and draw down assets too aggressively and retirees will become a burden to their children.

There are a couple of other reasons why SPIAs aren't used as often as one would think. First, fee-only financial planner/investment managers (even though they are fiduciaries) won't recommend them because they reduce the bread and butter of their operations - assets under management. Secondly, interest rates are at historically low levels and a primary determinant of the payout is the level of interest rates.

Any retired person who met with a financial planner 5 years ago, when 10-year Treasury yields were above 5%, has a legitimate question if they weren't asked to consider SPIAs for a portion of their assets.

SPIAs also are somewhat complicated in that you need to diversify among insurance companies, buy inflation protection, and carefully read the fine print. You have to know what you want going in because insurance companies are notorious for selling products consumers don't need.

As always, it could pay to get a planner to look over any offerings to provide objective advice before purchasing.