A retirement-fund paradox

By Felix Salmon
January 19, 2010
David Merkel is insightful when it comes to a huge status-quo bias in retirement funds. If we have a lump sum, we're loathe to convert it to a guaranteed income, even when we value the guaranteed income that we do have extremely highly:

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David Merkel is insightful when it comes to a huge status-quo bias in retirement funds. If we have a lump sum, we’re loathe to convert it to a guaranteed income, even when we value the guaranteed income that we do have extremely highly:

I have long been a fan of immediate annuities, particularly those that are inflation indexed, as retirement products for seniors. Yet, they do not get bought by retirees. Why? Well, insurance products are sold, not bought, typically, and when the agent sells an immediate annuity, that is his last sale on that money. They would rather sell a less suitable product that offers them another sale down the road. And, people like having flexibility with and control over their investments, even if that leads to less money for them in the long run. Annuitizing a portion of one’s lump sum lowers risk, and takes the place of investing in bonds in the asset allocation.

Most people like the reliability of their pensions, and Social Security, should it be paid, but do not seek the same thing when investing their private money.

I suspect that one of the problems here is that it’s almost impossible to tell whether or not you’re getting ripped off when you’re buying an annuity. Unless and until a vibrant and competitive market emerges in such things, you might end up buying a million-dollar lemon with substantially all of your life savings, and no one wants to do that.

I’m not sure how much the issue of having a rainy-day fund for unexpected medical costs comes into play here: at the margin it might actually be better to be on a fixed income than to have a large lump sum which could easily get eaten away by medical bills.

I do think however that people massively overestimate the returns they can get on their money, and they often dream of leaving their heirs more money than they retired with. Such dreams almost never come true, but they also never die. The question is, how much are they worth.

5 comments

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Thanks for mentioning my article, Felix! The immediate annuity market is reasonably competitive among insurers. The costs of the insurers cut the yield, though the yields are higher than Treasuries because of the spreads on risky debt that they invest in.

My view is annuitize some, but retain flexibility with the remainder. It’s not the best of both worlds as much as trying to minimize two different risks — longevity and inflation. It is one tough problem.

Posted by DavidMerkel | Report as abusive

More basic reasons why people don’t buy annuities:

(1) With the Fed buying down the long bonds, this may be the worst time in the past or future of the world to buy a life annuity.

(2) Vanguard, the most pro-consumer mutual fund company, offered a wonderful inflation protected annuity at a great price for many years. The insurer? AIG. Unfortunately, the “life” at risk in annuities is that of the insurance company as well as your own.

(3) 30 year TIPS, which didn’t exist until just a few years ago, are a pretty good substitute for an inflation adjusted annuity, aren’t they David/Felix? And instead of a 5% sales commission plus yearly fees for the insurance broker who sends you that nice calender every year, the costs are $0 via Treasury Direct, plus fifty bucks for a Texas Instruments financial calculator to calculate the withdrawal rate over your life expectancy.

Posted by maynardGkeynes | Report as abusive

Point (2) by mGk is what I wanted to point out; (3) doesn’t hunt, though. One of the nice things about an annuity is that it gives you a set (real) income for your actual life, not your life “expectancy”. You’ll find yourself reducing your drawdown rate as you go along so you don’t run out of money if you live longer than expected, and you’re going to have some money left over. The annuity is, in these senses, an insurance product.

Posted by dWj | Report as abusive

@dWj: thanks, good point on (3). But, remember that a big component of the financial risk of good longevity genes that inflation will kill you before Mother Nature does. TIPS “insure” against inflation well and cheaply. Balanced against that, is what you said, which I guess is the point of an annuity for most people.

Posted by maynardGkeynes | Report as abusive

Still TIPS have a defined life (30 years) which may not address those with good genes who are afraid of outliving their money, even given your valid inflation concerns. A properly constructed single premium, immediate annuity from an insurance company that one can have confidence in, with a reasonable premium, would be a valuable product for a whole class of people who are not comfortable managing their own portfolios and want the relative security of a monthly check. There is a reasonably large market here for Berkshire to get into if you’re reading Warren.

Posted by sportsbiz | Report as abusive