Annuities and the Puzzle of Income- New York Times
Here is still more information that documents the difference between a person with a pension and one without. This time, Richard H. Thaler from the University of Chicago writes of the difference in the New York Times this past weekend. In the article found here, Thaler considers two individuals, Dave and Ron, with identical ages and retirement portfolio balances to illustrate the point perfectly. Dave has a pension and Ron does not.
The lesson is clear; Dave has a substantial amount of guaranteed income for life whereas Ron has some difficult choices to make. Here it is straight from the article…
Dave can count on a traditional pension, paying $4,000 a month for the rest of his life. Ron, on the other hand, will receive his benefits in a lump sum that he must manage himself. Ron has a lot of choices, but all have consequences. For example, he could put the money into a conservative bond portfolio and by spending the interest and drawing down the principal he could also spend $4,000 a month. If Ron does that, though, he can expect to run out of money sometime around the age of 85, which the actuarial tables tell him he has a 30 percent chance of reaching. Or he could draw down only $3,000 a month. He wouldn’t have as much to live on each month, but his money should last until he reached 100.
Which option would you choose? It seems taking the pension route carries several additional benefits, all of which we’ve covered recently. And while many people malign the fact that defined benefit pensions are going extinct, the same kind of secure benefits can be found with an annuity. While that may be true, this article considers that relatively few people choose to purchase an annuity to fill the pension void.
In the author’s words…
Although people like Dave who have them tend to love them, old-fashioned “defined benefit” pensions are a vanishing breed. On the other hand, people like Ron — with defined-contribution plans like 401(k)s — can transform their uncertainty into a guaranteed monthly income stream that mirrors the payouts of a traditional pension plan. They can do so by buying an annuity — but when offered the chance, nearly everyone declines.
As we know, there is no shortage of economic evidence to verify the superiority of pension income.
Economists call this the “annuity puzzle.” Using standard assumptions, economists have shown that buyers of annuities are assured more annual income for the rest of their lives, compared with people who self-manage their portfolios…
If it’s this obvious, why don’t more people purchase annuities? Maybe you should tell me. I know first-hand that many consumers decline the annuity option, but rarely am I told exactly why. For starters, let’s take a look at the reasons mentioned in the article.
Stiffing Heirs– Many people feel that purchasing an annuity will decrease the likelihood of leaving a future inheritance. With the basic structure of most products, this is actually the case, although annuities can be designed to meet individual wishes.
Complicated Set of Choices– With the extreme amount of available annuities on the market, choosing one that fits perfectly is a daunting task. That’s exactly why this site was created. Here you can learn to grade specific contracts to find the most efficient way to produce long-term income without sacrificing other individual desires.
Payoff Is a Gamble– If profiting with an annuity contract requires that you live longer than average; many people would be justified to balk at the risk. The key to a suitable purchase is to not over-commit. By using an annuity to meet only your basic expenses you will keep additional assets available for the other financial goals you have.
If the economists are correct in saying that people with pensions and annuities are able to guarantee a higher level of cash expenditure over retirement, I think it’s worth raising all objections so you can give the option to purchase an annuity a chance. With a reasonable advisor, you should be able to take an academic approach to the question to verify a valid strategy.
I happen to think I’m a reasonable guy… and my clients would probably agree, it’s definitely worth closer inspection. What are your concerns with using an annuity for retirement income? An open discussion is the best way to answer every question. You’ll do yourself a disservice with any other approach.
I invite all your comments and look forward to helping you answer some very important questions.
Thanks for your time and have a great week!
Bryan J. Anderson