Thu, September 24, 2009
Annuities Might Make Sense For Some
Annuities have a bad reputation. They’re insurance contracts, which means they’re necessarily complicated. Often, they involve lots of hard-to-understand fees. And variable annuities, in particular, have earned a really bad reputation. Still, there is evidence that some form of annuity could be useful for many retirees.
Today I attended an excellent presentation at a NAPFA study group meeting by a colleague of mine, Rick Miller. Rick is a Ph.D. economist and a financial planner. He’s been researching the usefulness of annuities as a way of avoiding one of the major retirement risks most people face – running out of money – and his work suggests that fixed annuities are worth a second look.
When I get time, I want to write more extensively on annuities, but for now, let’s start with the nice, simple illustration Rick offered us this morning for how fixed annuities work: the tontine.
Consider the simple case of a tontine in which 100 people each pay $1,000 into a fund on January 1st. They agree that their money will be used to purchase a bond that yields 2.5%, and whoever among them is still alive on December 31st gets to divide the proceeds. Let’s say that at the end of the year, one person has died. The remaining 99 people divide up $102,500, giving each person $1.035.35 (assuming no administrative costs). Notice that although the bond only yielded 2.5%, each person receive a payout of slightly more than 3.5%. How? Well, through the mortality of their fellow tontine participant.
That’s the essence of how a fixed annuity works. In return for depositing a sum of money with an insurance company, you receive a payout that is defined either for a fixed period of time, or (more often) for the duration of one or more lives. The amount paid out is based on the life expectancy of the person or persons whose lives are involved. The company sells lots of contracts to a large population of people. The contract terms are set up so that the insurance company makes a profit (which may be modest, outrageous, or something in between), and the participants who live longest get a return that is subsidized by those who die early.
The main advantage of a fixed annuity is that you know how much you will get, and (barring the insolvency of the insurer), you can’t outlive the payout from your original deposit. If you’d invested the money yourself, you might have gotten a higher payout, but you would have taken on all the risk that your money would run out prematurely. The downside, of course, is that the annuity contract is irrevocable; once you’ve paid out the premium, you can’t change your mind. You also run a risk that the insurer may fail before you die (although some part of your annuity may be backed by a state guaranty fund, these typically limit coverage to about $100,000 per person per insurer).
Rick’s presentation provided a good argument for at least partially annuitizing a retirement nest egg. Obviously, this isn’t a solution for everyone, and anyone considering buying an annuity should analyze all the details of the transaction carefully and obtain professional counsel. But other academics and financial advisers are also examining the usefulness of annuities and coming to the conclusion that they could provide some needed protection for retirement funding. It will be interesting to see if more people become willing to use annuities after the stock market roller-coaster ride of the last year or so.
