An annuity provides people with a way to secure a stream of guaranteed income throughout their lives, protecting against risks like wealth depletion or outliving expectations. But economists refer to this situation as the annuity puzzle because so few individuals voluntarily purchase such products.
Economic models of rational human behavior suggest that those planning their retirement should logically purchase an annuity to protect them against spending down their assets and dying poor. Unfortunately, however, annuity markets seem to operate on different parameters than expected and many researchers have tried to understand why more people do not make greater use of annuities in their retirement portfolios.
One common argument against annuity purchases is that their fees and expenses are too costly to justify them, yet research suggests otherwise. One potential explanation could be that people overestimate their survival probabilities and therefore undervalue annuities with payouts tied directly to actual survival rates; however, IFS research shows this explanation may not hold water.
Behavioral researchers have also identified several forces that prevent individuals from making annuity purchases, including financial illiteracy, time restrictions for research and behavioral biases that influence how individuals evaluate financial options. Together these factors have conspired to stop annuity sales from rising further.
The Annuity Puzzle requires both researchers and financial professionals to develop strategies and educational resources that help retirees understand annuities’ value and how they can be used to meet retirement income goals. Thankfully, there are ways that can help people overcome this difficulty and take full advantage of its benefits.
Some individuals may benefit from partial annuitization strategies that allow them to use some of their savings to get reliable payouts for part of their lifetime while still having flexibility over their portfolios. Retirees might find value in bond ladder strategies designed to offer annuity-like guarantees while mitigating risks related to longevity exposure while still permitting flexibility within their investments portfolios.
An annuity should be part of your retirement income strategy. But it’s important to recognize that an annuity won’t fit everyone, and individuals should carefully consider their priorities, risk tolerance, bequest motives and any bequest motives when balancing these objectives in their plan. An increased understanding of annuities may lead to more retirees using them both to protect against longevity risk and achieve retirement income goals – for more information about LifeX’s capabilities as part of a strategy click here and request a demo demo here