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“Why don’t Americans buy more income annuities1?” is a question asked so frequently by academic economists that, within financial professional circles, it is known by a distinctive shorthand as “the annuity puzzle.”
Retirement researchers see that most Americans choose to underspend theoretically “safe” portfolio withdrawal rates in retirement, with most retirees expressing a strong preference towards living exclusively off portfolio income and dividends rather than risking depleting their principal. But in the current unstable economic environment, producing safe, reliable income over the course of an unknown retirement is a daunting goal for any financial professional. As a result, many Americans sub-optimize their retirement experience by spending less than they can afford. Economists often view single-premium immediate annuities (SPIAs) as a critical tool in providing a safe base of income for retirees, particularly for covering basic expenses such as food, shelter, healthcare, utilities, and transportation.
But few Americans feel comfortable buying SPIAs. Economists posit the following reasons for this discomfort:
1. Interest rates are at historic lows, keeping payments low, and leaving consumers thinking, “If I wait to buy, I can lock in higher payments later.” Unfortunately, that strategy has not proven effective over the last several decades of nearly continuous interest rate drops.
2. Because these contracts are annuitized, they can’t be rolled over into a new annuity after a surrender period, and some speculate that this impacts the desire of agents to promote these contracts.
3. Retirees fear the effects of inflation on buying power when a material portion of their portfolio is not invested in the market (SPIAs with COLAs have been available, but are rarely purchased).
4. Americans with smaller account balances already have a material “annuity” in the form of Social Security and are therefore already over-annuitized relative to the rest of their (usually underfunded) retirement portfolio.
5. Annuities have a reputation as being expensive, and consumers have been told by financial pundits to mistrust annuity representatives who put their compensation interests ahead of clients’ interests.
While the above items may impact consumer decision-making, they may not prove to be the most impactful psychological factor in the lack of consumer popularity for immediate annuities.
SPIAs may not be more popular because annuitizing an annuity, which includes the act of purchasing a SPIA, is a more permanent life decision than is the most mainstream decision we think of culturally as permanent – that is, marriage. Few of us would enter marriage with the intention to commute (divorce), yet sadly, 50% of American couples ultimately do divorce. This option to divorce is legally available to married couples, and this option has value to it whether it is exercised or not. While most annuitized annuities do have some liquidity options, few if any allow full commutation, hence the argument that the purchase of a SPIA is a more permanent decision for the purchaser than is getting married! Framed this way, it is no puzzle at all to detect why SPIAs are not more popular with purchasers.
Enter the contingent-deferred annuity.
Dr. Moshe Milevsky, the notable retirement researcher, professor, and author of Retirement Income Recipes in R: From Ruin Probabilities to Intelligent Drawdowns (Use R!), wrote about a different type of retirement-income protection that an insurer can offer to a consumer to overcome a number of the typical objections consumers voice against immediate annuities.
Since Milevsky wrote his book, what he referred to as a “ruin contingent life annuity,” has come to fruition in the form of the contingent-deferred annuity or, more simply, portfolio income insurance.
But what exactly is a CDA, and how does it work? In part two of this two-part series, “What is a Contingent Deferred Annuity?” I will examine the CDA in closer detail. We’ll go over the particulars of how a CDA functions, including the severability of the contract and the ability to keep assets with the custodian.
As CDAs become available on the market, it’s worth looking into what they are and how they can benefit retirees.
Michelle Richter is a principal at Fiduciary Insurance Services, LLC, and executive director of the Institutional Retirement Income Council, Inc.
Those seeking further information about the valuation and hedging of CDAs/RCLAs are encouraged to explore the following texts by Dr. Milevsky and the colleagues with whom he has been exploring RCLAs for over a decade, Dr. Huaxing Huang and Dr. Thomas Salisbury.
“A Different Perspective on Retirement Income Sustainability: The Blueprint for Ruin Contingent Life Annuity” H. Huang, M.A. Milevsky and T.S. Salisbury, Journal of Wealth Management. 2009, page 1-8.
“Valuation and Hedging of the Ruin-Contingent Life Annuity”, H. Huang, M.A. Milevsky and T. Salisbury, Journal of Risk and Insurance, 2014, Vol. 81(2), pg. 367-395
1Income annuities in this context means annuities that, with the first scheduled payment out of the contract, are viewed by the IRS as meeting “in annuity” status. Nonqualified annuities that are “in annuity” produce payments subject to an exclusion ratio for tax purposes. This category includes deferred-immediate annuities (DIAs).
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
