The Valid and Not-So-Valid Reasons for Rejecting Annuities
The “annuity puzzle” asks why more people don’t focus on longevity protection and purchase annuities. Those products are favored by economists and actuaries who study retirement planning, but not by the public. Those who attempt to explain the unpopularity of annuities often focus on a single issue, for example the aversion to large irreversible financial commitments.
But a host of impediments stand in the way of allocating funds to annuities. Some issues relate to brokers or advisors, and others involve their clients. Some are valid, but others are questionable and reflect irrational behavioral biases.
I’ll explain the contributing factors and discuss the challenges to overcome them.
Annuities are not for every retiree, and we can come up with valid reasons to exclude a significant share of the U.S. population as candidates to purchase annuities:
Insufficient funds/liquidity needs – It’s not possible to purchase annuities or other financial products without any savings. Various reports estimate that 20% to more than 50%of Americans have minimal or no savings. And for those fortunate enough to have accumulated at least modest savings, such funds may be needed for expenses such as out-of-pocket medical costs. This 2013 study by Reichling and Smetters estimated that lack of wealth would reduce the potential annuity market by more than 50%.
Low income – this is related to insufficient funds, but, for those on low incomes, Social Security may provide sufficient guaranteed lifetime income without the need for additional annuitization.
Other forms of annuitization – Defined-benefit pensions, more common in government jobs, may provide sufficient annuitization, and there’s an even stronger case for those in jobs that provide both a DB pension and eligibility for Social Security.
High wealth – For those with enough wealth to live off portfolio income or support retirement with a modest withdrawal rate, there is little need for annuities to protect against longevity risk. A nuanced argument could made that such individuals could still benefit by converting fixed income investments to annuities, but that’s a tough sell. Such clients are mostly focused on building a legacy.
Poor health – Annuities are priced for buyers in better-than-average health, so annuity products are unattractive for those with poor longevity prospects. The U.S. does not have a well-developed market for health-rated annuities that offer higher payout rates to those with various health conditions.
Large, irreversible transactions – People are understandably reluctant to enter into large, irreversible financial transactions. This has biggest negative impact on the sale of single-premium immediate annuities (SPIAs) and deferred-income annuities (DIAs) where there is no liquidity.
There are valid reasons why only a segment of the population are good candidates for annuities. If we think in terms of those retiring in a given year, perhaps only 20% of that cohort are a good fit for annuities. However, if we focus on clients of advisors, the percentage is higher because of wealth and income considerations.
It’s rare that people take their own initiative to purchase annuities – the suggestion typically comes from advisors or brokers. But a substantial share of the advisor community is either anti-annuity or against certain types of annuities.
Some advisors feel that annuities are a rip-off, based on high commissions and high fees that are charged to buyers. Such advisors typically are not interested in developing an understanding that distinguishes the high-fee annuities from those that offer a better deal for clients. For other advisors, their aversion may be directed toward SPIAs and DIAs, which lock up money for life. The segment of advisors and brokers who focus on their bottom line will have no interest in recommending products that remove assets from AUM fees and future rollover commissions. Also, the set-it-and-forget-it nature of SPIAs and DIAs make them a mismatch for advisors charging fees for continuing service.
For those who are anti SPIAs and DIAs, the more popular variable annuities (VAs) and fixed-indexed annuities (FIAs) provide a way to keep assets under management. Also, these products are built with more features that provide sales appeal, and they offer liquidity. We have advisors and brokers, some of whom oppose all annuities, and others who oppose SPIAs and DIAs, but favor variable or indexed annuities.
There are other impediments that stand in the way of advisors recommending annuities:
Platforms – The array of products that advisors can offer may be limited to those available on their RIA’s platform, and annuities may not be included.
Software – The financial planning software advisors use may be oriented toward investment products and not able to handle annuity products and their various features.
Legal risk – There may be concerns about recommending products where advisors could be held liable if an insurer offering annuities fails. The historical evidence indicates minimal risk, but advisors still may not be comfortable performing due diligence for long-term financial products.
Besides those valid reasons why annuities are not for everybody, there are questionable sources of client resistance. These issues are a bigger impediment for SPIAs and DIAs than for annuities in general, which may be why those products represent only a small share of annuity sales. I’ve structured this section of the discussion as POINT-COUNTERPOINT.
Lack of liquidity – POINT: Having the flexibility to tap investment funds when needed is important for many, so liquidity favors regular investments over annuities. COUNTERPOINT: Many people have sufficient funds and don’t need 100% of their financial products to be liquid, and the illiquid annuity products such as SPIAs and DIAs provide the largest benefits from pooling mortality risk. Also, liquidity considerations need to factor in the nature of retirement expenses. For example, if an income annuity is purchased to provide cash flow for essential expenses, illiquidity may not be an issue – the client can’t use the food money to go on vacation.
Unexpected mortality (“Hit by a bus”) – POINT: There’s often concern that the purchase of an annuity will result in a significant financial loss if the buyer suffers an early death. COUNTERPOINT: There’s typically less concern about looking into the future at the potential financial strains that may result from a longer than expected life. Annuitization simply provides mortality pooling – those with short lives subsidize those with long lives. It’s not a case of “the insurance company wins.” There’s also a further consideration if the annuity is purchased to provide cash flow to pay for basic living expenses in retirement -- the annuity payments and the associated retirement spending both end at death, so the spending is hedged, thus mitigating the risk to heirs.
Asset-to-Income translation – POINT: People tend to overestimate the amount of income that can be generated from a given amount of savings and may feel that annuity pricing is a rip-off. Jeffrey Brown and other researchers did a survey in 2011 that asked individuals how much they would be willing to pay for an additional $100 per month of Social Security. The median response was $3,000. Based on an actuarial present value at the time, the correct amount was close to $20,000, so typical respondent was off by a lot. With today’s lower-than-historical interest rates, income annuity payout rates are near historical lows, which adds to annuity aversion. COUNTERPOINT: It is worthwhile to compare annuity payout rates to the cash flow that can be generated from bond ladders with a maturity set at an assumed maximum age at death. With today’s pricing, the bond ladder might be 40% more expensive that a SPIA generating the same payouts.
Stocks versus fixed income – POINT: Stocks provide higher expected returns than fixed income investments such as bonds or fixed annuities, and therefore can be expected to generate more cash flow for retirement. Support for this belief is particularly strong among those who focus on historical stock returns. COUNTERPOINT: It makes a difference whether stock-return forecasts use historical data for returns or the premium over fixed income returns, which are significantly lower today in both real and nominal terms than historical averages. Also, it’s necessary to recognize the greater downside risk in a heavy reliance on stocks to support retirement.
Waiting for better rates – POINT: It may make sense to annuitize a portion of assets, but why not wait for higher interest rates and accompanying higher annuity payout rates before buying? COUNTERPOINT: Employing a waiting strategy means attempting to outguess the yield curve. For example, the 30-year Treasury yield was 4.58% 10 years ago. Waiting for better rates by holding cash would have meant earning close to zero for a decade, and still waiting.
The other side
I’ve listed 15 impediments to annuity purchase, but the natural question is, “What about the advantages of annuitization, and do they outweigh the negatives?”
There are indeed positives, but they tend to be different in character than the negatives. The positives relate to how annuities fit into a full financial plan and how they mitigate risk. There’s a lot of work required of advisors to properly present the advantages of including an annuity in a financial plan. The negatives, on the other hand, can be presented as soundbites: “Annuities are a rip-off.” “Don’t give up liquidity.” And even, “Don’t commit annuicide!” Of course, there may be soundbites that can be used to sell annuities like, “Here’s income you can’t outlive.” But that naturally leads to the question, “How much income?” and the negative behavioral biases mentioned above kick in.
There are also brokers who attract buyers without going through the work of presenting the products in the context of a full financial plan. “Here’s a way to get stock market returns without the downside risk.” Often these customers end up with products that are equivalent to mutual funds with annual expense charges of more than 3%. The products may offer liquidity after a 7- or 10-year surrender period, but it’s liquidity that has been significantly eaten up by high expense charges.
Comprehensive financial planning
This recent Advisor Perspectives podcast was a debate about whether RIAs should use annuities in retirement plans. The participants were David Lau who heads up DPL Financial Partners, a firm offering low-cost, no-commission annuities for the advisor channel, and Christine D. Moriarty who has worked as a financial planner and in educating advisors. As sometimes happens with debates, there was more agreement than disagreement, and both participants emphasized the importance of presenting annuities in the context of a full financial plan rather than as one-off sales.
Sales data for annuities sheds some additional light on this discussion, and the Secure Retirement Institute (SRI) provides a wealth of information on annuity sales. For 2020, it reported $219 billion of total annuity sales and categorized $60 billion as income-focused. Of this $60 billion, $8 billion were SPIAs and DIAs, and the remainder were VAs or FIAs with lifetime-benefit riders. These benefit riders have a lot of flexibility, and, unfortunately, it’s not possible to determine what proportion of these will be carefully managed by the advisors working with clients versus being left dormant. That $60 billion is a healthy volume of sales, particularly considering valid limits on the size of the market mentioned earlier. Perhaps the key issue in discussing the annuity puzzle is not how many annuities get sold, but how they get sold and how advisors work with clients in managing the options annuities provide.
Joe Tomlinson is an actuary and financial planner, and his work mostly focuses on research related to retirement planning. He previously ran Tomlinson Financial Planning, LLC in Greenville, Maine, but now resides in West Yorkshire, England.