At least since the seminal research of Menahem Yaari in 1965, financial economists have pondered why more people do not buy annuities to hedge longevity risk. Note Franco Modigliani’s famous statement when he received his Nobel Prize in 1985: “It is a well-known fact that annuity contracts, other than in the form of group insurance through pension systems, are extremely rare. Why this should be so is a subject of considerable current interest and debate.”
Income annuities remain widely unpopular yet would help to solve a variety of complex problems with which retirees struggle and which cannot be solved otherwise. Those who own annuities overwhelmingly say they are glad they do. Social Security, which is a lifetime annuity program, is an exceedingly popular program. Annuities provide more income than other investment choices and do so without market risk. And, subject to the claims-paying ability of the insurance carrier, an annuity will keep paying at the stated rate for as long as the annuitant lives. This quandary — why more people don’t buy annuities — is called the “annuity puzzle.”
Notwithstanding the above, Felix Reichling of the Congressional Budget Office and Kent Smetters of the University of Pennsylvania’s Wharton School have recently published a new working paper on annuity optimization that concludes that the low demand for annuities isn’t a puzzle at all. Instead, they claim that annuities are overused. Moreover, they suggest that, in the aggregate, the optimal level of annuity ownership may actually be negative, such that the true annuity puzzle may be why people buy them at all.
Reichling and Smetters’ research, while not yet formally published, will surely foster much reaction and debate. In a recent online interview with my friend and colleague Gil Weinreich, Research’s editor, Smetters hit the alleged annuity puzzle head on: “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.”
According to Smetters, longevity risk is just another in a list of frequently uninsured risks that people suffer at various points in their lives, but not the biggest one: “For workers, the big risk they face is that they could become disabled. For retirees, it is the uninsured medical costs not covered by Medicare or even Medigap policies. When you have one of these shocks — disability or a long-term care need — at the very same time your longevity outlook goes down. Had you bought an annuity ahead of time, you then have this disability shock and you have a need for income at that point.”
The strengths of this working paper are its recognition of and emphasis upon the health care risks we all (and particularly retirees) face and the careful explanation of how a health shock devalues existing annuity payments by both demanding more resources and lowering life expectancy. On the other hand, such a shock increases the value of existing life insurance.
Yet the paper’s major weaknesses (or so it seems to me, at least tentatively) are (a) the suggestion that because of the ways that annuities and life insurance work at cross-purposes, they are an either-or proposition; and (b) the suggestion that it isn’t a good idea — when finances and circumstances permit — to insure both health and longevity risks. Moreover, the paper completely neglects the market risk (sequence risk) associated with failing to purchase an annuity. When a retiree’s portfolio suffers a significant drawdown relatively close to retirement, the likelihood of portfolio failure during the retiree’s lifetime increases dramatically. That risk can be mitigated substantially by purchasing an income annuity.
The paper also neglects the possibility of using an annuity truly designed for longevity risk (a “longevity” or “advanced life delayed” annuity) that only pays out if the annuitant reaches a certain advanced age, often age 85.