Annuities may turn out to be one of those products that people don’t like to buy, but after they have taken the plunge, they are glad that they brought. One can imagine an option where some degree of annuitization of wealth could be built into 401(k) and IRA accounts. For example, it might be that the default option is that 30% of what goes into your 401(k) or IRA goes to a regular annuity that kicks in when you retire, another 20% goes to a longevity annuity that kicks in at age 80, and the other 50% is treated like a current retirement account, where you can access the money pretty much as you desire after retirement. If you wanted to alter those defaults, you could do so. But experience teaches that many people would stick with the default options, just out of sheer inertia–and that many of them would be glad to have some additional annuity income after retirement.
The theory of an annuity is that you insure against the risk of outliving your money. Economists tend to be big fans of annuities, and they view the reluctance of people to buy annuities as a behavioral economics puzzle.
I actually think that it is perfectly rational to shun annuities. My reasons:
1. You are charged more than the actuarially fair premium. Part of that is overhead and profit, and maybe part of that is adverse selection–the insurance company has good reason to fear that you are in better health than someone else your age. In any event, the result is that an annuity reduces your consumption possibilities by as much as would be the case if you over-estimated your lifespan by several years and budgeted accordingly.
2. Taylor notes that
people fear that they might need to make a large expense in the future, perhaps for health care or to help a family member, and if they have annuitized a large share of their retirement wealth they would lose that flexibility.
This is a very reasonable fear. An annuity is risk-reducing if the only risk you face is additional longevity. In fact, other risks may be more serious. You could easily find yourself needing to take out a loan if your savings are tied up in an annuity and your spouse requires a home health aide. (Speaking of which, long-term care insurance is something that I think does make sense, but you should buy it to get through age 75 and then self-insure thereafter).
3. It is reasonable to think in terms of declining consumer expenditures as you age. Will I really spend as much at age 90 as I spend at age 60? Medicare will cover many health expenses, and if I need to spend more of my own money on health care it is likely that I will have much less interest in vacation travel or buying a new car.
4. It is possible to substitute inter-generational insurance. If my mother-in-law had outlived her money, we could have supported her. From our family’s perspective, self-insuring in this way was cheaper than buying an annuity.
Many older folks own their own homes and continue to live in them as long as possible, which is like an inflation-hedged annuity of the (untaxed) net-imputed income of rent equivalent minus property taxes, insurance, and maintenance.
This is certainly true in my neighborhood (Maryland side of DC metro), despite the fact that the school proximity and house sizes really make it ideal for younger families (who can’t get in for lack of supply) and not the empty-nesters who refuse to budge.
Besides it being a common psychological preference, in some states there are also serious tax advantages / subsidies for seniors doing this vs. the costs of selling and moving to a small condo. And since shelter is a major expense and also an ok store of wealth which can be borrowed against (through home equity loans or reverse mortgages), it provides annuity-like levels of insurance.
So when Taylor says people don’t like buying annuities, he is sort of ignoring the most common way people establish annuity-like financial security in their lives when combined with the inflation-hedged, annuity-like government entitlement programs of Social Security and Medicare.
My hunch is that if one does the math, one would find that people are coming out ahead by choosing this strategy over paying annuity premiums.
I agree strongly with #3. I’ve had multiple family members live from late 80s to late 90s. But by around 85, they were no longer doing or spending much. They weren’t ill or institutionalized and were still enjoying their lives, but by that point, they no longer had the desire or energy for travel, and they preferred to putter around close to home. So my rough plan is to figure on money lasting until 85, and after that, if I’m still around, social security should be sufficient.
Dr King,
Can you elaborate on your reasoning behind the long-term care insurance strategy to be insured (by an insurer) through age 75, then self insure thereafter?
Once you hit 75, the chances of needing long-term care at some point are so high that I figure the cost of insurance will approach the cost of long-term care.
I can see your point if one initiated long-term care coverage at age 75. But if one initiated that insurance at, say, age 55, wouldn’t that lock in the premiums so that age 75 premiums are the same as age 55 premiums?
I have not seen such a policy. The market has been “evolving,” and not in a consumer-friendly way.
Thanks. I was misinformed on premiums not changing.
LTC insurance premiums have traditionally been set on an issue-age, unisex basis. The industry has been rocked in the last 5 years by many rate increases on these issue-aged policies, but the general structure still remains. A 60 year old can purchase a policy from a major insurer today for $2k per year, which may cover them for a $300k potential risk after 25 years.
Many who believe they have a high risk of a chronic illness will buy policies, and that anti-selection is difficult for insurers to combat.
Self-insuring a known 100k – 300k risk may not be as prudent as buying a policy with a 2k / yr premium and holding it for 30 years, even given some potential rate increases …
The possibility of inflation keeps me from buying an annuity. The annuities inflation indexed annuities seem to poor values.
An inflation-adjusted annuity aims to solve the problem by giving you an automatic cost-of-living increase every year. But the cost is steep.
Things like MetLife, Inc. Preferred Series seem like a better deal to me. The chances that met life has to stop paying the dividends on their preferred stock but still pays full value on the annuities (or more likely in a collapse, the Feds pay out the annuities and liquidate the company) seem pretty small. A life extending tech could put a hurting on the annuity parts of the business but the life insurance part would do well.
Buddy of mine is the grandson of a couple who bought an annuity – with every dime they had scraped together – in the 50s, then lived into the 80s. $14000 a year looked nice and comfortable in the 50s. By the 80s, their son was kicking in a big check every month. I realize this is anecdata, but it puts me right with you on inflation risk.
Arnold,
Spending at 90? I’m guessing you are 62. So 2014 + 28 = 2… carry the 1… 2042!
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