June 7, 2011 — Before you answer that question, consider this situation. Assume for a moment that you are age 65 and could have two retirement choices. In the first you get a portfolio that, conservatively managed, would generate $4,000 per month until it runs out of money at age 85, or $3,000/mo. until you run out of money at age 100. If you die before the age in each scenario, your heirs get whatever is left. With the second choice you get the same amount of money invested in an annuity that would also produce $4,000/mo. – except that you would get that income for as… long as you live. Your heirs get nothing, no matter when you die. Which option would you choose?
The New York Times ran an interesting article last Sunday on this situation, “Annuities and the Puzzle of Income“. The Times asked a similar question with the first option the same (lump sum managed to produce either $4,000 or $3,000). But to illustrate a point they offered a different hypothetical second option – a pension that pays $4,000 a month for the rest of your life, nothing upon death. Almost everyone took the pension option. The Times article was trying to make the point is that the very popular pension example is really the same as an annuity – a very unpopular choice. The illustration has merit in this day of disappearing defined benefit pension plans. With no pensions to comfort us in our old age, we have become the default managers of our retirement funds and options.
We think most people avoid the annuity and choose to manage our own money. A big reason for that is because we feel like we will get cheated if we die before our break even point: our heirs will get nothing with an annuity, but inherit the remaining principal if we manage the money. Other important reasons for the unpopularity of annuities are that they are complicated and hard to understand, and there has been some unscrupulous marketing in the past.
Annuities – So Unpopular
Richard Thaler, who wrote the article, wanted to call attention the undeserved unpopularity of annuities. He believes people fail to pay enough attention to the scenario described in our first paragraph – what happens when you run out of money at age 85. That is a dire situation, and not all that unpredictable. A man age 65 has a 30% chance of living to age 85, and a 20% chance of getting to age 90. Women have even longer life expectancies. His point: consider the annuity option – it’s probably the safer option and most like a pension. He also makes a good point for why annuities can manage to keep making payments after the typical investment portfolio runs out of money: if you are lucky enough to live to a very old age, the earlier deaths of people in the annuity pool provide the money for your extended benefits.
Comments: What would you do, and why. Please share your opinions in the Comments section below.