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Annuities, usually thought of as deadly dull, have been hot in the press lately – the topic of an early June New York Times piece by economist Richard Thaler and the lead article of the June 18 Barron's. Both confront the "the annuity puzzle," which can be succinctly stated as, "Why do so few people buy annuities?" Economic theory would predict robust demand for this financial product, especially as the workforce ages, but the reality is quite the reverse.
Economists have wrestled with the annuity puzzle for at least 45 years, beginning with Menahem Yaari who demonstrated that it is rational for people to turn their wealth into guaranteed lifetime income — that is, annuitize. Ever since, economists have tried to reconcile Yaari's sensible analysis with the real-world lack of annuitization by developing more nuanced models of rational behavior. These efforts have produced an abundance of equations but not much insight. More recently, the newer field of behavioral economics has tackled the puzzle by applying concepts like loss aversion and status quo bias. These efforts have proved more fruitful.
But something is still missing. All of this economic analysis has focused on buyer behavior, treating individuals who buy or don't buy annuities the same as consumers who buy televisions or automobiles. But unlike as with most consumer goods, the initiative to purchase most financial products, including annuities, comes from financial salespeople – insurance agents, stockbrokers, bank representatives and other advisors. Most financial purchases involve what economists refer to as information asymmetry – in which the seller possesses an information advantage over the buyer. To better understand the annuity puzzle, we need to study the sellers.
We can gain some insight by applying a seller perspective to two different types of annuities – those used primarily for savings (including variable annuities, fixed deferred annuities, and index annuities), and those that produce guaranteed lifetime income, known as immediate annuities. Here's a salesperson's view.
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Savings annuity: The seller receives a generous commission on the deposit – much more generous than for a certificate of deposit or mutual fund. The seller also receives trail commissions on the account balance. After a few years, the surrender charge period ends, and the seller can then recommend that the buyer roll the funds into a new annuity with more state-of-the-art features. This, of course, starts a new cycle of commission generation.
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Income annuity: The seller receives a commission on the deposit amount, and that is the end of it. From the seller's standpoint, the funds essentially vanish. The assets turn into income, and there are no trail commissions, funds available for rollover or fees for assets-under-management.
It should come as no surprise that annual sales of savings annuities come in at about $240 billion in the US, and income annuity sales run less than $10 billion. (The surprise may be that the $10 billion isn't zero!)
Do we have a problem?
Some would argue that all the talk about the so-called annuity puzzle is a waste of time — there is no problem. After all, $250 billion is spent per year on annuity sales, and more popular savings-types products, like the variable annuities from Prudential and MetLife, also provide access to lifetime guarantees. These products also provide more liquidity and flexibility than the income annuities.
However, we do have a problem if we care about the value products provide for the purchasers. The high commissions come with a price in the form of high expense charges and features that offer more perceived value than real value. Product complexity masks the impact of the commission expenses. It's not really a contest between savings products and income products — it's a contest between high-commission/low-value products and those that provide better value with lower compensation costs.
So we do have an annuity puzzle, but it is not about aversion to purchasing annuities. Rather, the question is about providing value. Can we find ways to develop and distribute annuity products that provide better consumer value than those being sold today? Or are we stuck with a seller-centric system where the only way to distribute products is to take most of the value from the purchaser and channel it into commissions?
Solutions
There is now a lot more focus on retirement income products than there was a few years ago. As might be expected, a lot of that attention involves a seller-driven push to expand the market for the high-commission/low-value products. But there are also product and distribution ideas that emphasize providing better value and addressing retirement income needs more directly.
Here are some examples:
- The SecurityPlus Annuity is a proposed product developed by Pamela Perun and her colleagues at Aspen Institute's Initiative on Financial Security. They advocate using the Social Security Administration to sell inflation-adjusted immediate annuities. Those claiming Social Security could purchase these annuities directly and increase their retirement incomes above the level they could get from Social Security alone. This program would not completely overhaul the retirement income system but would instead attract retirees to buying additional lifetime income from a safe, reliable and popular source.
- Teresa Ghilarducci, who heads the Schwartz Center for Economic Policy Analysis at the New School for Social Research, has proposed comprehensive reform of the US retirement system. She advocates using Guaranteed Retirement Accounts to compete with the existing 401(k) system by automatically turning accumulated wealth into annuities. This would add a tier of retirement income for all workers above that provided by Social Security. Her book, When I'm Sixty-Four, makes the case for overhauling the retirement system and received a lot of attention when it came out in 2008.
- Investment companies Blackrock and Dimensional Fund Advisors and the software company Financial Engines have each developed innovative approaches to help participants turn defined contribution plan balances into lifetime income. All three utilize investment strategies during the working-and-savings years that build retirement income and control income risk rather than accumulating lump sums. They all include easy ways for participants to transition from savings to guaranteed lifetime income. DFA's Managed DC product is based on development research from economist Robert Merton, and William Sharpe has been a key player in the development of Financial Engine's Income +.
These are just three examples, but they illustrate the kinds of innovative thinking that may hold hope for solving our redefined annuity puzzle.
is an actuary and a financial planner and is managing director of Tomlinson Financial Planning, LLC in Greenville, Maine. His practice focuses on retirement planning. He also does research and writing on financial planning and investment topics.
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