About 25 years ago, I sat in a packed room at a National Association for Variable Annuities conference (now the Insured Retirement Institute). There, I watched Dick Austin, one of the original annuity pioneers, deliver a compelling argument for the inevitable substantial growth in immediate annuity sales.
The argument was as sound then as it is today: Baby boomers were going to retire en masse and would need guaranteed income to replace the pensions that were quickly disappearing. Boomers have indeed been retiring — at a rate of 10,000 per day, and most do lack a sufficient level of guaranteed income. Yet, according to LIMRA’s U.S. Individual Annuities report for the fourth quarter of 2017, total immediate annuity sales in 2017 were $8.3 billion, just over 4% of total industry sales. What went wrong? What, if anything, can we do to make Dick Austin’s vision finally come true?
Immediate Annuities Secure an Income for Life
Uncertainty makes retirement planning difficult. There are three things we don’t know: 1. How long the client will live 2. The average portfolio return and the sequence of those returns (also known as “sequence of returns risk”) 3. Whether or not there will be unexpected expenses in retirement, such as health care
Incorporating a single-premium immediate annuity or a deferred income annuity in a client’s financial plan can help solve most, if not all, of the first two unknowns. With these products, your clients can purchase an annuity contract with a single premium payment. That annuity contract then pays a guaranteed income that starts immediately (SPIA) or at a time in the future (DIA).
By securing income for as long as the client lives, the immediate or deferred income annuity becomes a way to insure against living too long — mitigating unknown number one above. In addition, the client and financial advisor know it is far less likely to be necessary to reduce income levels in response to poor returns in the early years of retirement, thereby mitigating risk number two above.
Not only do these products reduce some of the uncertainties associated with retirement planning, but with an income guaranteed for life, these annuities can create a “personal pension plan” for the growing number of clients that find themselves without a pension. Clients can consider an immediate or deferred income annuity as a supplement to Social Security — a role pension plans held previously.
What’s to Hate?
Sounds pretty good, right? A stream of guaranteed income for life to replace disappearing pension plans and supplement a client’s portfolio and Social Security. So, why do people long for pensions and love Social Security, but find an immediate annuity so unappealing?
For many clients, just the word “annuity” is enough to make them tune out any presentation that outlines the benefits that they may otherwise find so appealing. But even if the industry succeeds in drowning out the very vocal annuity haters, other obstacles still exist for both SPIAs and DIAs.
Below is a list of challenges these products face and why I believe advisors and clients don’t use them more often:
Misconception of the purpose: Rather than focusing on the primary purpose of the annuity — securing an income for as long as they live and protecting against the sequence of returns — clients worry they will die before receiving payments at least totaling the amount invested, thereby allowing the insurance company to “win.” They forget that, like any other form of insurance, what they are really doing is insuring against risk.
Focusing on returns: Rather than view an annuity as a way to insure against living too long, many clients tend to think of an annuity as just another investment. Therefore, they often become too concerned about the return on that investment. Immediate and deferred income annuities should be positioned as a source of guaranteed income, not return generation. In fact, studies by Professor Jeffrey Brown of the University of Illinois concluded that consumer demand increases when an annuity is presented in terms of income streams as opposed to an investment alternative. (See “Behavioral Impediments to Valuing Annuities: Evidence on the Effects of Complexity and Choice Bracketing” by Brown et al, National Bureau of Economic Research Working Paper, December 2017).
Self-funded income: I believe that while everyone would like a pension, few are willing to fund it out of their own pocket. While I would argue that individuals with a pension and Social Security recipients did indeed fund these income payments — paying 6% from each paycheck — no one had to write a separate check to fund them. When an investor sees a large amount deducted from his or her investment account, it creates a very different reality.
Regulations and compliance: Academic studies indicate the most efficient retirement portfolio allocation for some savers — particularly those with between $400,000 and $2 million — could call for as much as 40-50% of the portfolio to be allocated to either an immediate annuity or a combination of an immediate annuity and deferred income annuity. (See “Why Bond Funds Don’t Belong in Retirement Portfolios,” by Wade Pfau, AdvisorsPerspectives.com, Aug. 4, 2015). This allocation could provide a sufficient amount of income, similar to pension plans historically, and transfer some risk from the investments in a portfolio. However, regulators likely would view such an allocation negatively and, therefore, an allocation like this would not likely clear a firm’s compliance hurdles. Even if it did, most clients would likely balk at handing over so much of their retirement savings to an insurance company.