Annuities are one of the most hotly debated products in the financial world. Many financial planners believe their costs make them unusable in any situation, while many others point out their tax benefits and unique characteristics that help reduce the longevity risk of outliving your assets. In fact, many policymakers have suggested that putting more of your retirement assets into immediate annuities would help avoid the risks involved in stock market volatility and other pitfalls of having to invest your own retirement nest egg.
Yet a recent study (link opens PDF) from researchers at the Congressional Budget Office and the National Bureau of Economic Research concludes that for many individuals, real-life challenges make putting too much of your assets in immediate annuities a risky mistake. Let’s take a closer look at the study and other historical research on this important question.
The state of the annuity market
For nearly half a century, many annuity advocates have relied on a groundbreaking research study from the 1960s. This study argued that anyone who didn’t want to leave money to future generations would do best to invest in annuities rather than alternative investments.
Yet annuities aren’t nearly as popular as that early study suggests they should be. In light of tepid sales and annuity-guarantee risks taken on during the financial crisis, annuity sellers Metlife Inc (NYSE:MET) and Manulife Financial Corporation (USA) (NYSE:MFC) have taken substantial steps in recent years to revamp their annuity businesses, cutting benefits in some cases and limiting sales in others. Hartford Financial Services Group Inc (NYSE:HIG) and AEGON N.V. (ADR) (NYSE:AEG)‘s Transamerica unit last year sought to pay annuity owners either to modify their contracts or to purchase them outright.
Why haven’t annuities been more popular among investors? The CBO study attempts to explain the reason for the disconnect between the 1960s study’s predictions and financial reality.
Having a safety net
The idea behind the original 1960s annuity study was simple. Assuming no costs, annuities pay more than regular fixed-income investments because they include what’s known as a mortality credit, which comes from those who die before their life expectancy and therefore forfeit a portion of their original investment in the annuity.
But in its attempt to explain why so few investors actually buy immediate annuities, the CBO study critically assessed the earlier study’s assumptions. For one thing, annuities are far from costless, with most charging fairly substantial fees to cover mortality risk and other expenses.
More importantly, though, the 1960s study didn’t allow for the possibility that health problems would shorten life expectancies and create immediate cash needs. If you’ve annuitized your entire life savings, then an illness or injury could leave you in an untenable financial situation, as you no longer have access to your original investment principal and can only draw from the monthly payments the annuities gives you.
Moreover, if an injury or illness reduces your life expectancy, then the value of your annuity falls dramatically. Even in a world where you can buy or sell annuity contracts freely on an open market at any time, immediate annuities can’t handle the risks of unexpected health problems.
