A good explanation of the perceived problems of annuities

There is much to recommend in purchasing an annuity at retirement to manage the risks and uncertainty of longevity. It’s well known though that surprisingly few people who have the option to purchase an annuity do so.

Richard Thaler presents some of the common perception problems with annuities in this article in the NY Times. The basic message is still as it has been for decades. Individuals are reluctant to pay a large portion (often the majority) of their life savings to an insurer with the risk that they will die in a few years and “not have got their money back”. The peace of mind that should come to the policyholder turns into a matter of stress.

The bequeath motive is strong – and amplified by a lack of understanding of exactly how long we’re likely to live in retirement these days and how much money will be required. Those to whom many plan to bequeath may ultimately become the source of support when the income draw-down products are depleted with no longevity guarantee to boost the funds available.

It’s a good explanation although he doesn’t break much new ground. He also doesn’t talk about the concerns some potential policyholders have, in some countries at least, of whether the insurance company who sells the annuity will definitely be around over the next 40 years come what may.  This is more common in developing markets with weaker regulation (probably a good reason to have concerns) and less history of annuities (a cultural bias that will probably disappear over time).

Mr Thaler doesn’t propose any solutions for the insurers in boosting sales – a common “fix” is to combine a traditional pay-until-death annuity with a guaranteed minimum period or a death benefit (either for a limited term or at any point).  These adjustments reduce the “risk” of “making the wrong decision but purchasing an annuity but only living for a short period”.

There’s no free lunch.  In the same way that cash-back bonuses on short-term insurance products actually increase the average cost of insurance and reduce the risk-transfer from insured to insurer, these guarantee periods increase the cost of annuities.

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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  1. And in South Africa, they can be, depending on the source of funds, /horribly/ tax inefficient, as they turn all gains (capital, tax exempt dividends, interest that would otherwise benefit from both the basic and over 65’s interest exemption, etc) into fully taxable income taxed at your ordinary marginal rates.

    Then there’s the negative perception of the “investment” part of the life assurance industry with its history of missold policies, and the fact that the risk transfer can look insufficient when you see inflation-adjustment rate caps and you have had personal experience of high-inflation. Not only are you not certain of inflation adjustments meeting your needs, but psychologically you’ve given up control and can’t do much about this situation when it occurs (apart from find part-time work or call up your kids). I suspect this loss of control and being “at the mercy of the insurer”, combined with the negative press of the last decade odd, discourages a lot of now-retiring South Africans from purchasing annuities, even before the facts themselves are given an opportunity to speak.

    1. Those are broadly valid points around the views around investment products offered by insurers in South African and common perceptions. However, the unattractiveness of annuities as a particular product class, both in South African and around the world, remain independent of these issues.

      You make two points specifically about annuities. The inflation issue is certainly more relevant in SA than in most developed countries. That only reflects inflation risk rather than longevity risk. The tax point is valid, up to a point. Given that the appropriate backing assets for annuities are fixed income assets, the tax treatment as income is the same as what an investor could achieve if invested in a similar portfolio (but without the longevity protection).

      An issue I didn’t raise in the original post relates to the miss-selling of “living annuities” (serial recipient of the most misleading product name in the world award) from a longevity risk and charge/commission perspective. Government’s plans to open up these products to a range of institutions is premised on competition decreasing costs but I don’t think it’s been thoroughly thought through just yet.

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