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July 02, 2013 at 10:25 AM
For nearly 50 years, financial economists have scratched their heads wondering why more people, at least those without significant bequest motives, didn’t buy annuities.
They provide higher income than bonds and protect against the risk of outliving one’s wealth. Why people would refuse to feast on what may be the only free lunch economics offers—higher consumption and elimination of risk at the same time—has so bothered academics that the question has its own catchy nickname: “the annuity puzzle,” which legions of aspirants have sought to solve.
Now, defying all the conventional wisdom, a team of two researchers, Felix Reichling of the Congressional Budget Office and Kent Smetters (left) of the University of Pennsylvania’s Wharton School, have published a new working paper on annuity optimization that concludes that low demand for annuities is no puzzle at all.
In fact, the authors state that the optimal level of annuity ownership may actually be negative, such that the true annuity puzzle may be why people are not shorting annuities.
Reichling and Smetters’ thesis, though not yet formally published, is likely to spark significant debate within the academic and financial services communities. To get an early briefing for financial advisors, AdvisorOne spoke with co-author Smetters, who is especially known among advisors as the founder of middle-market financial planning firm Veritat Advisors, which LPL acquired from him in 2012.
A distinguished scholar, Smetters did not hastily launch into this controversial finding. He said he has been thinking about the issue for about a decade and has been taking his time getting the mathematics right while honing a computer model that has been crunching through hundreds of thousands of optimization problems.
AdvisorOne: So who should and who shouldn’t be buying annuities?
Smetters: The conventional wisdom has been that people should annuitize a lot, and the big mystery was why don’t they annuitize a lot.
The point of our paper is mainly to simply ask: Does it actually make sense that people should buy annuities as much as conventional wisdom says? And the answer is “no” for most Americans.
The average American should probably not annuitize any of their wealth. Younger people should not. Even most people at retirement should not.
Those who should buy annuities have already incurred health costs or are quite elderly and would get large value for buying an annuity. Those are very exceptional cases.
But most younger people should negatively annuitize, which they can do by buying a fair amount of life insurance.
Your paper seems to argue that the reason for negatively annuitizing turns on the health care risks that people face at various life stages. Can you elaborate?
