Commentary MARK SHEMTOB
Unraveling the Annuity Puzzle
THOUGH NOT NEARLY AS INTRIGUING as the search for the
grand unified theory, the annuity puzzle has been the source of much
study, debate, and consideration since its formulation in 1985 by Fran-
co Modigliani, a social scientist and Nobel laureate in economics. The
mystery at the heart of the puzzle is why retirees claim to like the idea
of receiving a guaranteed lifetime pension yet seldom are willing to
part with their nest eggs to secure it. The problem in the annuity puzzle
is how to reconcile retirees’ “likes” with their actual behavior. But dig-
ging deeper, I would argue there’s no puzzle at all.
Put simply, the reason many retirees
don’t purchase single premium insured
annuities (SPIAs) that provide guaran-
teed lifetime income is they don’t think
the reward justifies the risk. While the re-
ward—insured lifetime income—is clear,
the risks associated with the purchase
of a SPIA aren’t as easily quantified. Not
being able to measure a risk can cause po-
tential buyers to overemphasize it. Those
who consider purchasing SPIAs often
demand benefits (rewards) greater than
their fair actuarial value, based strictly on
mortality, interest, and expenses.
Risk Versus Reward
What are the risks that the potential
buyer of a SPIA considers? One is the
possibility that the insurer will be un-
willing or unable to pay the guaranteed
benefits. Based on experience, the like-
lihood of this happening is quite small.
State guaranty funds provide insurance
to cover insurer failures, further limit-
ing the chance of not receiving benefits.
Still, the possibility isn’t nonexistent and
is perceived as a risk by some retirees.
Another hazard is locking in a fixed
payment that future inflation could se-
riously erode. SPIAs can be sold with
cost-of-living increases, but insurers
must charge for this benefit by reduc-
ing the initial level of payout. Because
of inflation risk, many financial advis-
ers recommend that their clients avoid
SPIAs and instead consider diversified
investment portfolios coupled with a
scheduled lifetime withdrawal pattern.
Then there’s liquidity risk. This arises
if a retiree requires or desires funds that
are no longer available because of the irrevocable nature of the SPIA purchase.