Tuesday, November 21, 2017

The Annuity Puzzle

A big challenge in retirement is spending enough to be happy without running out of money. The main problem is not knowing how long you’ll live. This is called “longevity risk.” We are forced to plan for a long life whether we’ll live long or not.

One way to eliminate longevity risk is with an annuity. The idea is to hand your money over to an insurance company, who then promises to pay you monthly, even if you live much longer than they expect.

According to Meir Statman in his book Finance for Normal People, “people are reluctant to annuitize, a reluctance we know as the ‘annuity puzzle.’” Statman identifies a number of “behavioral impediments to annuitization.”

We are averse to “transparent dips in capital.” Seeing your portfolio take a big drop hurts, even knowing that you’ll get lifetime income in return. Also, the “money illusion” makes “a lump sum of $100,000 seem larger than its equivalent as a $500 monthly annuity payment.”

“Availability errors deter people from annuitizing further because images of outliving life expectancy are not as readily available to people as images of many kinds of death that might befall them soon after they sign an annuity contract.” Regret aversion is also involved because of the possibility “their heirs would receive only pennies on the annuity dollar.”

Finally, we get to the easiest-to-understand reason for avoiding annuities: they have a “smell of death.”

All these behavioural reasons that people avoid annuities sound perfectly plausible. However, there are also rational utilitarian reasons for avoiding the annuities available to people.

First, let’s consider a simple fixed payout life annuity. The return on such annuities is a mixture of long-term bond rates, mortality credits, and embedded fees. This forces people who prefer the higher expected returns of stock investments to give them up to get mortality credits. One good solution might be to take just your bond allocation and buy an annuity if the embedded fees aren’t too high. But, it can be quite reasonable to prefer to keep a significant allocation to stocks.

There are annuities available whose variable payouts are related to stock investments. However, the investment fees buried inside these products are extremely high.

If we had an annuity option that resembled a well-run shared-risk pension plan, then it would certainly make sense for people to use it to get the advantage of mortality credits. Until this is available, expect this annuity puzzle to persist.

18 comments:

  1. Your final paragraph was my solution, and luckily I could buy into a Pension Plan, making retirement seem more straight forward. All I need to do now, is not die.

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    1. @Alan: Your pension plan is even better than what I suggested because it isn't shared-risk.

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  2. I avoid annunity plans for two reasons: they are a "sold" product, which means there are sales commissions and (possibly / likely) high admin costs. Second, my investments with a bank self brokerage minimizes fees and I live comfortably off the dividends and occasional stock sales. The bulk of the capital remains untouched, available for major expenses -- including nursing care.

    My wife unexpectedly contracted cancer and died within 8 months. If we had had an annunity, I suspect that her capital would be gone forever, but now the widower has both shares of capital.

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    1. @Eric: I'm sorry you lost your wife. Avoiding "sold" products is an excellent filter. Most of the time, couples get joint annuities, which means they keep paying until both people are gone (at the cost of lower payments). However, it sounds like you're getting along well without annuities.

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  3. I plan to defer CPP and OAS as much as possible. I think of this as equivalent to purchasing an annuity.

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    1. @blitzer68: I plan to do the same thing. I figure that the extra I pull from my portfolio from 65 to 70 is the premium for the increase in CPP and OAS. By my calculations, this is a good deal.

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    2. I once calculated that if I invested the equivalent of my CPP contributions at a 4% real return, I could buy an equivalent annuity. For that reason I would prefer to manage my own investments. I'm not sure what type of annuity I looked at since this was several years ago but I'm sure the price was higher than average because of the low interest rates.

      I'm not sure what the equivalent value is for deferring benefits.

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    3. @Richard: CPP incorporates many rules that advantage some people over others. When calculating your benefits, you can drop out 17% of your lower-paying months, those who take care of young children can drop out several years, and married couples get survivor benefits. So, someone who can't take advantage of these rules will get a much worse deal from CPP than others will.

      However, none of this affects the value of deferring benefits. You've already faced an advantage or disadvantage based on the benefits rules. If you look at how much you need saved up just in case you have a long life, CPP deferral is a very good deal.

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    4. @Richard This doesn't affect the decision about whether to defer CPP or not, but also note that your CPP benefit relative to your contributions depends a lot on the timeframe in which you contributed. CPP was originally an unsustainable pay-as-you-go system The front end of the baby boom benefitted disproportionately before it was reformed in 1997 to double contribution rates for the same benefit. Those born before about 1960 get more than the value of investing their contributions, those born 1985 or later get only about 2/3 the value of investing their contributions.

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  4. The thing with annuities that bothers me and that nobody seems to talk about is the increased credit risk. You're allocating a large portion of your capital to one company and assuming that the company doesn't go belly up. Perhaps not a large risk, but stranger things have happened.

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    1. There is insurance on annuities like CIFC for bank deposits. You can search for more information.

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    2. @J.K. Reid and @Juhl Asan:

      According to Assuris,

      "If your life insurance company fails, your Payout Annuity policy will be transferred to a solvent company.

      On transfer, Assuris guarantees that you will retain up to $2,000 per month or 85% of the promised Monthly Income benefit, whichever is higher."

      So, protection is capped, and I'm not sure what happens with variable payouts and payouts that were supposed to increase each year (e.g. 2% to offset inflation).

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  5. The following comment is from Kathy Waite at Your Net Worth Manager:

    Michael, how about for those who worry about outliving their money (often single women) add up their expenses take off CPP and OAS and buy an annuity for the difference between that and the total required. Don't annuity everything you have. Just create an indexed pay check big enough to cover basic expenses. Make sure it has a 10 year guarantee so your estate gets the capital back and use an insurance person who can shop around. Not some one who is tied to one of the big companies. I have been looking for one who can do it for a flat fee and think I have found one. We do investments and financial planning on a flat fee basis . Moshe Milveskys Pensions Your Nest Egg is on my to read list about this subject. Good article, thank you!

    Kathy Waite

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    1. @Kathy: There's no doubt that people could benefit from eliminating longevity risk for at least a basic income. The challenge is that the options available are quite poor. As @blitzer68 points out, delaying CPP and OAS is a good way to boost basic, guaranteed income, and get access to excellent pension plans. I think this is likely a better way to create a guaranteed basic income than buying a typical annuity.

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  6. And then there is the "CPP and OAS Deferral Puzzle". I think that I read somewhere that less than 2% of retirees defer to age 70... Many may not be able to afford to defer but most of those who can, don't.

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    1. @Garth: There are many possible explanations for this. One is that we seem to have the "greedy algorithm" wired into us. This means that when we can't see the globally optimum approach, we make a series of locally optimum choices in the hopes that collectively they are at least close to globally optimal. If we focus solely on the first year after turning 60, it's obviously better to take CPP at 60 than wait until 70. I could concoct other possible explanations based on regret or anchoring.

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  7. I look at an annuity as a loan to the life insurance company for a term equal to average life expectancy of the annuitant, that is, the middle of the bell curve of an insurance company's annuitant pool of a given age. So for a 60 year old male, for whom the middle of the bell curve is 84, it's a pool of loans amortized, on average, over 24 years from the life insurance company's perspective. I then look at a loan amortization table for a 24 year period and come up with an interest rate that applies to the annuity payout the insurance company is offering. With most payout annuities it works out to somewhere around 2.5 to 3% of interest with the remaining 2% or so of the payout being return of principal. Looked at as a near zero risk investment and adding in the benefit of the life insurance company taking on all of the longevity risk, it's really not too bad a deal.

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    1. @John K: The risk that remains is inflation risk. It's hard to imagine that at some time in the future it will take $3000 to buy what $1000 buys today, but it will happen.

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