By Mark Miller
CHICAGO Aug 19 Economists have long argued that
there's a perfect financial product for retirement: the humble
immediate income annuity.
It's a straightforward proposition: Fork over a big chunk of
cash to an insurance company, which starts sending a monthly
check when you retire - or later. The cash keeps coming as long
as you live.
The immediate annuity, which also goes by the name of single
premium income annuity (SPIA), offers effective protection
against longevity risk, which is the risk of outliving your
money. It comes with an intriguing special sauce,
euphemistically known as the "mortality credit." That simply
means insurance companies use the unpaid assets of folks who die
at younger ages to pay out to those who live longer, and it
allows an annuity to have comparatively high payout rates.
For example, a 65-year-old male currently can buy a $100,000
annuity with a payout rate of 6.72 percent, according to New
But economists also talk about an "annuity puzzle." Namely,
if SPIAS are such a perfect retirement vehicle, why do so few
people buy them? Sales totaled $7.7 billion last year, according
to LIMRA, the insurance industry research and consulting group.
That's a drop in the bucket compared with IRAs and workplace
retirement plans, where $5.3 trillion were invested last year,
according to the Investment Company Institute.
Not much has changed this year. Sales figures released on
Monday by LIMRA show that $3.4 billion in immediate annuities
were sold in the first half of this year, down a bit from the
same period of 2012, when sales totaled $3.7 billion.
One oft-heard response to the annuity puzzle is that
retirees fear a SPIA won't pay off if they don't live very long.
Another big objection is the loss of liquidity associated with
an annuity purchase. What happens if you get really ill, or
lightning cracks your roof in half?
Now, that fear is getting a close look in a study by two
economists, who attempted to quantify what happens to the value
of an immediate annuity when an unexpected health shock occurs.
The economists, Felix Reichling of the Congressional Budget
Office and Kent Smetters of the Wharton School of Business,
found that health shocks can produce a unique double-whammy for
annuity buyers: a sharp decline in life expectancy, which cuts
the remaining value of the annuity, and the unmet need for cash
to pay for care. They conclude that for risk-averse retirees, or
for those with limited retirement assets, the best move is to
avoid annuities altogether.
Reichling and Smetters relied on Monte Carlo-style
probability modeling to arrive at their conclusions, and their
paper already has stirred predictable industry criticism over
their assumptions and economic modeling. "Proving that people
like liquidity is the ultimate 'duh' moment, says Matt Grove,
senior managing director at New York Life. "We know that from
our own research."
The research by Reichling and Smetters appears at a time
when the Obama administration has been pushing for regulatory
changes that would encourage the addition of annuity options in
workplace plans - specifically, a little-used form of annuity
known as a longevity policy. These are deferred annuities that
can be bought well ahead of retirement with payouts delayed to
an advanced age.
New York Life has had good success with a deferred income
annuity product introduced in 2011, called the guaranteed future
income annuity (GFIA). It's sold over $1 billion in premiums
since July 2011 introduction. The GFIA allows a buyer to set a
future date to start receiving income, pay an initial premium as
low as $5,000 and then continue to make additional premium
contributions along the way. The product is aimed at buyers in
Proponents argue that income annuities protect not only
against longevity risk, but the risk of under-spending in
A New York Life analysis of data from the University of
Michigan and the Employee Benefit Research Institute found that
roughly two-thirds of retirees who have $150,000 in savings at
age 65 tend to spend no more than they receive from guaranteed
income sources, such as Social Security and pensions.
"What this is telling us is that they are afraid to spend
because they value the liquidity," Grove says. Conversely, he
says, retirees who have purchased annuities or long-term care
insurance policies, which protect against health shocks, make it
possible for them to spend a bit more freely in the early years
The questions about liquidity and health shocks raised by
Reichling and Smetters may show the need for a different type of
insurance product, argues Michael Kitces, partner and director
of research for Maryland-based Pinnacle Advisory Group. "To me,
the paper points to the value of pairing an annuity with a
long-term care insurance policy," Kitces says. "A hybrid SPIA
and long-term care product could be interesting."
Insurance companies - start your engines.