Tuesday, July 24, 2012

Deciphering the Annuity Puzzle

My Advisor Perspectives column for July is now available. It is, "Deciphering the Annuity Puzzle: Practical Guidance for Advisors." In this column, I explain the economic theory behind the puzzle. The puzzling issue is why people do not annuitize more of their assets at retirement since it removes longevity risk from the equation and allows for higher lifetime spending power. I also describe in more detail about the idea that people who do not annuitize should plan to reduce spending to some extent over their lifetime to account for their decreasing survival probabilities as they age. Then I provide various explanations for why the lack of annuitization may not be as puzzling as the basic model shows. Finally, I consider a few ways to help get over the behavioral stumbling blocks against annuitization.  


  1. Wade - absolutely love your work!!!! Another piece of the annuity puzzle may be taxes. If you are funding the SPIA outside of a tax deferred account, there could possibly be a very large lump sum capital gains tax to consider. Funding a $500k SPIA outside of an IRA could involve a very high tax if the money being used had a high degree of unrealized gains. Just a thought

  2. This is a great article. Many thanks.

  3. Thanks to both of you.

    About taxes, yes, that's right. There could be very big tax hit indeed when trying to convert over to a SPIA. Policymakers may want to look into that issue.

  4. I think the behavioral issues with annuities are more serious than your article indicates. First, there is the endowment effect, which is likely to be very strong with a big lump sum of money. Second, there is the fact that annuities are most attractive to the risk averse, but the risk averse are those most likely to be concerned about dying so early that they lose money on the annuity. Third, the benefits of the annuity, as opposed to the lump sum, are in the distant future, and many people, probably especially those of low to modest means for whom an annuity is most suitable, discount the future heavily (which may be part of why they are of low to modest means in the first place). And there is the worry, not too rational in most cases, about the insurance company not being able to afford its promises. So, behaviorally, it is a “perfect storm” in favor of the lump sum. Unfortunately, I’m not sure how best to get around all this. Perhaps annuities with guarantees (15 year certain or refund certain) might help to some degree, even though they decrease (though often only slightly) the utility. Federal guarantees for the annuities, perhaps modeled on FDIC coverage for banks, would be helpful if there were any political will to set up such a system.

  5. (Same person as last comment.) One other incentive to annuitize that would be good, although probably politically impossible, perhaps justly so since I really dislike complicating the tax code further. Currently, social security income is treated as partially or completely tax free depending on income. Suppose that, for those at or beyond the full retirement age, instead of applying just to social security, that treatment was extended to annuity income from qualified accounts, up to some total limit (social security plus annuity). (Perhaps the largest possible full retirement payment for someone with the same birth year.) That would provide a tax incentive to annuitize for those with low social security payments, and therefore presumably with low liftime incomes, but little or none to those with higher lifetime incomes. There would as always be complexities, for example government employees partially covered or not covered by social security, but there are already special rules for many such people. The tax cost might not be too large because nearly all of those using the benefit would be in low brackets anyway. I don't know how workable this is, but it's a thought. It might be a good "nudge" at relatively low cost.

    1. Thank you for the thoughtful comments and further emphasis on the importance of behavioral issues!