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Ask nearly any financial economist and they’ll tell you retirees ought to have at least some of their savings in a life annuity—a financial product that provides a steady source of guaranteed income over the buyer’s lifetime. Consumers also say they like the idea. But here’s the weird thing: Almost nobody buys life annuities. Even people who do purchase annuities don’t buy this kind.
In a new paper for the National Bureau of Economic Research, an all-star team of financial and retirement experts explains why these products are so valuable for older adults, yet so disliked by consumers. And it makes some important suggestions about what to do about it.
Their ideas include public policy changes, including defaulting a fraction of savings into life annuities at retirement; more creative ways for insurers to market these products; and improvements in consumers’ financial literacy. Their hope: People will buy more life annuities if they better understand the economic risks of old age and how these products can help protect against them.
Managing Uncertainty
Aging is filled with uncertainties. It is effectively impossible for most retirees to predict their future health, how long they’ll live, and what will happen to their investments or the economy. In other words, you can’t know for certain how much money you’ll spend over your post-retirement lifetime.
That’s the advantage of these annuities. Whether the stock market goes up or down, despite what happens to inflation, and—most important— no matter how long you live, lifetime annuities deposit a steady, regular payment into your bank account. Every month. For the rest of your life. Think of them as your personal, old-school, defined benefit pension plan. Or simply as insurance against outliving your money.
Annuities already are part of nearly every retiree’s life. Those defined benefit pensions are life annuities. Social Security functions like a life annuity. And for people in their 70’s and older, so do the Required Minimum Distributions they must take from traditional tax-advantaged retirement accounts such as IRAs and 401(k)s (though not from the Roth versions). Even big lottery winnings often are paid as annuities rather than a lump sum.
Few Buyers
Several recent studies (see here) report that roughly 90% of retirement plan participants like the idea of guaranteed lifetime income in old age. Yet, consumers are reluctant to buy. Even those attracted to the idea of annuities won’t buy these. Of the $460 billion in annuity products sold last year, only about $14 billion were the most popular form of life annuity.
Part of the problem is that life annuities are easily confused with many other sounds-like products, such as variable annuities, many of which essentially are mutual funds wrapped in pricy insurance policies. While they share the annuity label with life annuities, they generally are investment vehicles rather than guaranteed income products.
The most common version of a life annuity, and easiest to explain, is a Single Premium Immediate Annuity or SPIA. You give an insurance company or investment firm a lump sum of money and, in return, you receive a fixed payment every month for as long as you live.
There are many variations on the theme. You can provide a payout for your spouse after your death, though that will reduce the payments over your lifetime.
You also can purchase a deferred life annuity, which, as the name implies, will delay monthly payments until you reach, say, age 75 or 80. That will lower your initial contribution. And it provides important monthly income at an older age when you may need it for medical care or long-term care.
Why The Reluctance?
But the key is these all provide a fixed, regular, guaranteed payment for life. Despite that promise, the biggest impediment to buying seems to be human behavior.
One big reason why consumers shy away from annuities is what is known as loss aversion: I write this big check to an insurance company in exchange for lifetime income. But what if I get hit by a bus and die a year after I buy the annuity? I’ve given up a huge chunk of cash and received almost nothing in return.
Similarly, it often is difficult for retirees to give an insurance company a share of the retirement savings they worked so hard to build. And a retiree can be reluctant to write a big check today but not “get my money back” for years to come.
Changing Behavior
What can be done to change consumer behavior?
It would help to teach consumers about longevity risk. It turns out that younger people tend to underestimate how long they’ll live (90 seems unimaginable) while older adults tend to overestimate their lifespans (90 seems pretty close).
The financial industry also could better design products that address these psychological barriers. For example, firms could offer products that replace big single premium initial purchases with much smaller, regular contributions. Or make products less complex and easier to understand. And firms could reframe life annuities as longevity insurance. Which they are, rather than as investments. Which they are not.
While the authors believe all these steps are important, they argue that a key change is defaulting consumers into life annuities.
We know this nudge can work for other retirement savings. Behavioral research shows that a default opt-out option has significantly increased retirement savings. Many of us have seen it: Your employer contributes a minimum amount of your pay into a retirement account, unless reject the option. The funds also may be automatically invested into lifecycle (or target date) mutual funds, tied to your age, unless you opt out.
It would work the same way for a life annuity. Your employer would put a portion of your retirement savings into an annuity starting at, say, age 65 or 67, unless you requested that it does not.
A few large investment firms, including Vanguard and Fidelity, have begun adding annuities to their lifecycle (or target date) funds. But these generally are structured as an optional choice, not an opt-out.
Guaranteed lifetime income is not an easy sell. But as we live longer, less predictable lives, and as government support become less certain, it seems like a pretty good idea.
