Annuities - Love Them Or Hate Them? Financial Advisors' Daily Digest

by: SA Gil Weinreich

Summary

Let's lay down our arms and try to have a level-headed discussion about the function of annuities, their advantages and pitfalls.

Jeff Miller weighs the week ahead, looking at the range of possible directional shifts at the Fed.

Institute for Innovation Development discusses a methodology to systematically uncover new business ideas.

Our discussion on Friday about whether "bonds" are bad generated a debate between readers as to whether "annuities" are bad. As I mentioned in Friday's post, we need to define our terms, but for now, let's hear what the debate is all about.

On the one hand, commenter hawkeyec, coming out in favor of annuities, writes:

"In addition [to Social Security], my wife and I created two-life annuities with all our IRAs and 403b retirement accounts. Doing this guarantees us a minimum of 5 significant monthly checks for all of both our lives. The total is more than our combined salary before retirement. These annuities automatically satisfy all IRS minimum withdrawal requirements, cannot be outlived, required no commissions at purchase and have already returned what we paid for them. What's not to like?"

Indeed, there is quite a lot to like about that if we try to stay level-headed about this. Hawkeyec goes on to mention that these life annuities are issued by large (presumably sound) insurance companies, and he himself reports that the only negative is that this money cannot be used for purposes of a bequest to heirs. He writes:

"The only downside I can see is that when we are both dead there will be nothing to inherit. Who cares? That is not my job. My job is to protect mine and my spouse's future in retirement."

It's hard to fault him for this as well. Every parent wishes to leave something for the kids (and indeed he points out he is doing just that with monies from another account). But that's not always financially possible, and it seems more prudent to ensure you won't be a burden on your children than to gun for a financial windfall if doing so risks your own solvency. This calculation depends on individual circumstances. I'm just saying that based on the perspective he himself provides, his approach seems eminently reasonable.

Finally, hawkeyec points out one more reason he is satisfied with his decision:

"Also I don't have to guess how much I can 'take out this year,' I wish someone on here would do the kind of analysis of annuity alternatives that we see for 'guestimates' about retirement portfolios."

Before we turn to the critics, let's just say at the outset that hawkeyec's articulate defense of annuities should make him the poster child of financial economics. Economic theory postulates exactly what he is talking about. The theory goes by the inelegant term "utility maximization," and it's the consensus view of the profession, which is why a) economists generally love annuities (at least in theory); and b) feel that financial advisors and financial media are committing some form of malpractice by steering away from them.

With apologies to the economics profession for the following gross simplification, utility maximization essentially holds that people are happy when they spend money. That's not exactly the same as saying that money buys happiness, but rather that money buys food, clothing and shelter, and after that it can buy an education or a car, and if there's still more money, it can buy a night out on the town or a vacation somewhere. Economists' utility maximization curves slow down as we progress through these stages. If you ate out last night, you're less tickled doing so tonight.

What all this means as far as annuities are concerned is that by providing a steady income that cannot be outlived, they are great utility maximizers. Your insurance-company-provided paycheck will more or less buy you the same known amount each month (minus inflation, unless you purchased an annuity with inflation credits). If you're still with me, then you recognize that in theory at least this all makes sense. After all, if you had a choice between an annuity that paid out $10,000 a month ($120,000 annually), who wouldn't prefer that to $200,000 one year, $40,000 the next year and so on? For many, the latter approach (though providing the same income over two years) would mean the life of Riley in one year, then living in a trailer the next, and so on.

Now it's the critics' turn. Annuities as discussed in the popular press are generally reviled, and indeed Heidi, Helga, Clarissa and Desiree of Sleepless in the Alps "really, really hate them." But to their credit, they don't yodel their antipathy at a decibel that makes argument impossible. To the contrary, the Swiss insomniacs provide an intelligent counter-argument:

"We don't believe in the invincibility of any insurance company contract, we don't like the stupid high fees built into them, and we don't like the surrender of access to capital they feature (especially to retirees)."

That's probably the most succinct counterargument I've seen and, guess what: They're right too. In just a few words, they provide three common-sense objections: a) insurance companies cannot be relied upon; b) the fees are too high; and c) why tie up your capital?

Before explaining why their points are well taken, I'll excerpt one more comment from Friday's post, from Walter Scott, whose focus is on the first of the Swiss gals' arguments. He writes:

"Insurance companies checked their morals at the door when they incorporated. Delay, defend, deny -- this is how they pay claims. Bad faith claims against insurers are far too common."

Okay, with the arguments now out on the table, how can two opposing arguments both be in a sense correct? If you were paying close attention, you noted that in discussing "utility maximization," we were discussing economic theory. Even though this theory is generally accepted, there is of course still a world of difference between a theory and its practical implementation, which is why the positions of economists and financial practitioners are frequently at great variance.

Perhaps because I am neither an economist nor an advisor, the reconciliation between these positions seems fairly obvious. Using Sleepless in the Alps' succinct formulation, if insurance companies can't be relied upon in general, find one specifically that can be relied upon; if the fees are generally too high, find low-fee products; if tying up one's capital is disadvantageous, then don't tie it all up - you can annuitize part, even a small part, of your capital.

I'm not suggesting everybody run out and get themselves an annuity. As hawkeyec notes in his comments (not quoted here), Social Security itself is a classic annuity. It's somewhat amusing that people who "hate" annuities usually love Social Security. From an economic perspective, they're exactly the same! But the difference in the real world goes far to explaining the hate: Commercially available annuity products are typically costly and complicated and there's a feeling abroad that some issuers abuse their customers with high commissions and surrender fees.

Once again, though, both sides can be right. Somebody who is, let's say, paying "too much" for an annuity may still be maximizing his utility (i.e., retiring contentedly) to a greater degree than his annuity-hating friends suffering a financially volatile retirement (while paying less money to the financial services industry).

This article has gone on too long (apologies), but allow me to tie up a few loose ends in bullet-point fashion:

a) Even annuity haters seek to maximize their utility. Just saving for retirement is an endorsement of the theory that says having an income makes people happy. In other words, if you're saving some money for your future, it is because you recognize you might be miserable without one once you stop working.

b) Do insurance companies harm consumers as Walter Scott contends via bankruptcies, bad faith and fraud (as he says in comments not quoted above)? There are enough claims to this effect that I have seen over the years to warrant a wary consumer. And yet logic suggests to me that this is concern is especially valid in cases of home, auto or disability insurance. It's hard for me to imagine (and please correct me if I'm wrong) that an insurance company fails in its obligation to pay annuity benefits. There's far less room for uncertainty. You give a specific sum of money for a contractually defined monthly payment. The case is perhaps comparable to life insurance. Usually, a person's death is fairly verifiable, so the insurance company simply pays the claim. Finally, even in areas where there is more doubt about the insurance company's probity, that doesn't stop most people (including, I would bet, Walter Scott) from purchasing life insurance, home insurance, disability insurance, etc. One simply performs due diligence to the best of their ability to get a reasonable policy.

c) Two of the comments on Friday's post wanted to see specific research - one of them on the question of how annuities stack up. Here's where we really need to start defining our terms more precisely. If we're talking about, say, variable annuities which are extremely complex products, experience tells me that this is extremely difficult to do to the degree that I would urge a very high degree of caution if you encounter such "research" elsewhere online. It takes tremendous expertise that most financial journalists, financial advisors and even the financial executives who develop these products simply do not possess. A few highly trained consultants or academics have the requisite knowledge, and you should be willing to pay them for an evaluation.

d) Lastly, there are all kinds of annuities. The simplest - single-premium income annuities - do not require expert evaluation. You can purchase them online and compare them simply on the basis of which offers a higher paycheck. There are other kinds of annuities that offering other potential advantages that are less simple and for which professional advice is warranted.

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