Why Retirees May Be Reluctant to Embrace Annuities

March 5, 2010

The March 1, 2010 issue of the Wall Street Journal included their monthly personal investment update section.  Page R4 of that section contained a long article entitled Making Your 401(k) Last, by Tom Lauricella, which which focused on a discussion of converting 401(k) savings into annuities. 

Annuities have become very popular with politicians, financial advisers and other self styled experts as evidenced by the number of articles endorsing them.  The March issue of Money Magazine had two short articles on the wisdom of annuities in retirement.

Annuities are a great product and should be considered in one's retirement planning but, like everything else, there are not an automatic fix for everyone's retirement plan.

As the Baby Boom generation rapidly approaches retirement, politicians, self styled experts and the media have all suddenly discovered annuities and have decided that a guaranteed monthly income for life is just what the retiring boomers need.

The problem is, no matter how they package and pitch annuities, the majority of people are not buying.

Don't get me wrong, annuities are a very good product and investing in one can be a wise retirement planning choice.

As I explained in a previous Hub, Using Annuities to Guaranty Retirement Income for Life, an annuity is basically a reverse life insurance policy in which, instead of making small monthly payments in exchange for your beneficiary receiving a large sum of money if you die as occurs with life insurance, an annuity requires that you give the insurance company a large sum of money up front in exchange for a guaranteed monthly check for the remainder of your life.

As one of my finance professors put it, with life insurance you are, in effect betting that you are going to die soon while the insurance company is betting that you will live a long time. The reverse is true with an annuity as you are betting that you are going to live a long time, thereby getting more back than you paid in, while the insurance company is betting that you will die soon thereby allowing them to keep most of your money. The reality is more complex but this little joke captures the essence of the two products.

Despite the advantages of an annuity, and there are many, for a retiree, most people are reluctant to purchase one with their retirement savings.  So reluctant in fact that many of those supporting annuities are looking for ways to force people to invest in annuities for retirement.

The Wall Street Journal article makes this point early on saying Many investors just don't seem to want these annuities – even if a bevy of financial experts say that the products are in their best interest.  The article then goes on to list some of the reasons why the experts feel people are reluctant to invest in annuities and these include:

–                   people distrust annuities because historically the high commissions paid to annuity sales people resulted in high fees to the buyers of annuities.

–                   People fear turning all or most of their retirement savings over to an insurance company with no or very limited options for getting it back other than in the monthly payments.

–                   People fear they will die long before getting all but a small portion of their money back (and unlike stocks, bonds and CDs in an IRA or 401(k), the insurance company generally gets to keep the balance of the money not paid out in monthly income payments).

Another argument that was previously made was inertia or the fact that people were too lazy to give thought to their retirement needs so they simply let their money sit in more traditional investments instead of following the experts' advice and putting the funds into an annuity. 

However, when some 401(k) plans took the step of automatically enrolling workers in an annuity and investing all or part of the employees contribution in the annuity unless the employee opted out, most opted out even when that required their overcoming some roadblocks the plan put in the way of opting out.  Thinking differently than what experts are recommending is not automatically a sign of stupidity or laziness.

As a baby boomer approaching retirement myself, I find it interesting that this article and the others pushing annuities haven't looked at the history of the past half century for clues to this reluctance, on both the part of both the boomers and their children, to pour retirement funds into annuities.

The first is inflation.  Just as the Great Depression of the 1930s did much to shape the financial thinking of my parents and grandparents generation, so too, has inflation had an influence on our financial thinking. 

A major weakness of annuities is the fact that with a basic annuity the monthly income is fixed and, when inflation occurs the purchasing power of that income will decline leaving the annuitant with less and less spending power each month.  While the monthly payment will continue to arrive unchanged in terms of the amount every month its purchasing power will depreciate steadily and this has the same effect as cutting the payment.

Worse still, when income taxes are taken into consideration, the taxes will remain the same while the value of the income decreases.  On the other hand, if the individual had left the money in the 401(k) and a market crash caused the value of the securities to fall, as happened during the 2008 crash, the individual would also have to reduce their monthly withdrawal, thereby reducing their monthly income, in order to conserve their funds.  However, by withdrawing a lower amount (which is, in effect, reducing their monthly income) their income taxes would be less. 

The second possible concern, which the article did touch on, is trust.  People are living longer which means first, that they have experienced considerable change in the world during the 60 to 70 years before they retire and, second, a healthy person faces the possibility of living as much as twenty, thirty or even forty years after retiring. 

Mathametically, annuities are a very safe investment.  There is no reason why a lump sum payment can be converted into a guaranteed monthly income for life.  So long as the insurance company issuing the annuity invests the funds conservatively and uses a conservative interest rate and good actuarial data when calculating the promised payment there is no reason why the purchaser of the annuity cannot expect to receive the promised income for life no matter how long he or she lives.

However, this assumes the funds are managed well and the company issuing the annuity is financially sound.  While many life insurance companies have solid, conservative reputations and have been in business for a century or more there are newer companies in the market which, while well run, have not stood the test of time. 

While life insurance companies survived the 2008 financial crisis in good shape there was a week or two during the height of the crisis when fears were raised that some of them might encounter serious problems and need bailing out (they are, after all, big investors in the mortgage market).

Despite the fact that life insurance companies have weathered financial storms well during the lives of the boomer generation, other aspects of life have changed drastically over this period.  Companies, whole industries and even nations and empires have disappeared since our youth. 

Even more disturbing has been the loss of pensions.  Many of us lost employer paid pensions due to voluntary or involuntary (due to downsizing) exits from our jobs.  While a blow to future plans, the immediate impact was minimal as we found other jobs.  However, we did quickly embrace 401(k) plans, in which ownership rested with the employee and not the employer, when they came out.

It is this segment of the population, people approaching retirement who have 401(k)s and/IRAs with large balances who are one of the target markets for annuities (the other target is young people early in their careers).  To get any type of reasonable monthly income from an annuity, a person generally needs to invest $100,000 or more which, for many people approaching retirement, represents their entire retirement savings.  This requires a large degree of faith and trust especially for people who have already had the system fail them.

More significant are the experiences of current retirees who, ten or twenty years into retirement, have suddenly had their monthly payment cut.  This is especially true of retired union workers in industries like steel, airlines and automobiles who were promised large pensions only to have the employer behind the pension file for bankruptcy and shed the pension whereupon the U.S. Pension Guaranty Corporation came to the rescue and saved the pension but had to reduce the monthly payment.

Let me emphasize right here the pensions and Social Security are not annuities even though they act like annuities in that they promise an income for the remainder of a person's life.

Observing the fate of underfunded employer sponsored and controlled pensions (especially the old fashioned employer paid plans) and Social Security which is rapidly approaching insolvency and the only question in most people's minds is when, rather than if, it will fail, makes many people hesitate to turn over and lose control over a working lifetime's worth of savings.

These experiences, plus the fear of inflation which this generation has experienced first hand, are probably at the root of much of their reluctance to embrace annuities. 

Of course, a final factor, also not considered, is the boomer generation's love of independence.  Most of us don't like being told what to do and that includes being told what to do by self-appointed nannies.