Richard Thaler on the annuity puzzle

His latest Economic View column.

Imagine a set of 65-year-old identical twins who plan to retire this summer after long careers. We’ll call them Dave and Ron. They have worked for different employers and have accumulated retirement benefits worth the same amount in dollars, but the benefits won’t be paid out the same way.

Dave can count on a traditional pension, paying $4,000 a month for the rest of his life. Ron, on the other hand, will receive his benefits in a lump sum that he must manage himself. Ron has a lot of choices, but all have consequences. For example, he could put the money into a conservative bond portfolio and by spending the interest and drawing down the principle he could also spend $4,000 a month. If Ron does that, though, he can expect to run out of money sometime around the age of 85, which the actuarial tables tell him he has a 30 percent chance of reaching. Or he could draw down only $3,000 a month. He wouldn’t have as much to live on each month, but his money should last until he reached 100.

Who is likely to be happier right now? Dave or Ron?

Continue here.

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  • Askey

    As a professional fee-only personal financial adviser to scores upon scores of the soon-to-be retired, Thaler has touched on at least one common reason the 2b-retired shun annuities:  the annuity products are complicated and most of us working stiffs are not savvy enough to be confident in getting into contracts that bind our money irrevocably.  But the greater barriers to the greater usage of annuities in retirement are two:  Suze Orman and insurance sales practices.  Suze has scared many naive annuity candidates away by her bumper-sticker statements about how bad annuities are.  But the hustle practiced by insurance sales people is its own turnoff to many.  The hustle is justified if those who sell annuities depend on the high commissions (7% in some cases) they pay out for their livelihood.  Annuities and other retirement-oriented insurance products would face less public resistance if they could be offered by advisers who take no commissions.  In the few cases where such products exist, the retiree should have complete confidence absent a costly load or commission that the product is in his or her best interest.  Now we’re getting into the debate about the fiduciary standard vs. the suitability standard, the difference between an adviser and a broker.  So, some of the public’s resistance to annuities is clearly traceable to the conduct and sales incentive practices of the manufacturers of annuities and their agents.

  • David

    I have two concerns with annuities. First, the regular ones don’t make any adjustments for inflation. While $3,000 a month sounds nice in the first year, after 35 years at 3% inflation you’re down to $1,066 in today’s dollars. So you’re living not with $36k/year but with $13k/year. It doesn’t take hyperinflation for this to be an issue – over the past 35 years, the average inflation rate has been 4% (at which rate the annuity would be worth $760 in the last year, adjusted for inflation). I see no value in this scheme, it’d have to be something that keeps up with inflation. You can buy inflation-adjusted annuities, but those come at a significant cost. I presume they’re targeted at people afraid of hyperinflation and who are willing to pay a significant premium to be protected against that. However, 3% inflation is enough to matter over a period as long as retirement.

    Next, an annuity is as much guaranteed as the “protected” structured investment vehicles offered by Lehman Brothers. If an insurance company goes bankrupt (not all that unlikely), most states limit annuity protection to $100k. You cannot make it for 5 years on $100k even before accounting for inflation, much less for the entirety of retirement.

    After all that, I’m still not convinced that a conservative managed payout fund isn’t going to provide a better solution. I’m protected against defaults of any financial institution (funds are managed separately), holdings in stocks and short-term bonds mitigate the risk of inflation, and I can withdraw money if I need it for a vacation or repairs. Additionally, with an annuity you initially make a decision for how much you want per month and you’re stuck with that until you die. Do people who are starting retirement really know how much they will need per month?