Solving the “annuity puzzle”

Economists have been worked up about an “annuity puzzle.” An annuity is bought near-retirement (say at age 67) by giving an insurance company a chunk of money; in return the company guarantees a specified annual income till you die. So annuities should be irresistible to anyone afraid of outliving their money – presumably all “rational” people. The “puzzle” is that very few people buy annuities. Economists have been busy thinking up reasons why people who don’t buy annuities are “irrational.” But most people are actually rational – they just factor in things that economists ignore. What are these factors?

An annuity should free you from return risk (earning poor returns on your money) and longevity risk (outliving your money) – but does it? Most people know that interest on bonds is currently at a historic low, even factoring in low inflation. But today’s annuity prices also turn out to depend strongly on today’s bond returns, which means that annuities are now expensive by historical standards. An annuity paying income of $1 a year now costs around $25 at age 67. Is this price justified?

In the US in 2010, a male at age 67 is most likely to die at 90. If you live to 90, an annuity will return -- over your lifetime -- less than the purchase price. That’s doing worse than stuffing your money in the proverbial mattress. But what if you live a really long time? Let’s pick age 102, because the odds of living past that are less than 1 in 100. Now an annuity purchase of $25 at age 67 gives you a total payback of $35. At this price you earn just a shade over 2% on your $25 for a 35 year investment with nothing back. Finally something better than the mattress: is there something to an annuity after all?

By the way, the $25 price I use (based on Black Rock’s CORI) is for a relatively simple annuity with limited inflation protection. An annuity that covers your spouse if you die first will cost more, and is still worth nothing after both die.

But now we come to the kicker: an annuity is a “guaranteed” payment (in my example, of $1) every year till you die. Who provides the guarantee? Well, the insurance company. What can you do if the insurer goes bust? Well, nothing except lament your bad luck. But surely insurance companies don’t default. Well, in fact they do and they have: in the last 87 years insurers have gone bust in 1929 and again in 2008. That’s a default risk of over 2% -- twice as high as your 1% chance of living past 102.

Can you assess default risk for individual insurers? It is possible to find ratings --Vanguard has a useful web site that prices annuities sold by different insurers, and that lists a score from 1 (low) to 10 (high) for each insurer’s financial strength. But Vanguard’s minimum acceptable score is 4, and for a policy I checked they list AIG with a score of 5.5. Is that weak or strong? Even more to the point, there might be people who would accept an annuity guarantee from AIG, but after the recent financial crisis many people would not. There’s yet another problem with assessments of insurance companies – they are done by ratings companies like Standard & Poors or Moody’s. These are the same companies whose unreliable ratings contributed to great turmoil in the last financial crisis. Can we trust their ratings?

So a rational person at age 67 would not, in my view, buy an annuity today. What are the options? One: invest in a mixed portfolio of low-cost stock and bond index funds, using an allocation rule that can tilt slowly towards bonds. Two: over several years, ease into a fixed income portfolio with a mix of long-term treasury and tax-exempt muni bonds. Three: keep an eye on annuity prices, and when they are low, ease into a portfolio of annuities from different insurers. Finally, remember that Social Security is the best annuity out there, and make sure you help it stay that way.

Shripad Tuljapurkar