The secret to a secure retirement or just another overpriced financial instrument?

As life expectancy in the United States continues to rise, experts in the financial services industry have developed instruments to assist those preparing for retirement. One of these tools is an annuity, which upon its purchase, will provide an individual with an income stream for the duration agreed upon in the contract. While this may seem like a simple and relatively straightforward solution, a TIAA-CREF study found that only 14% of Americans have actually purchased an annuity, despite 84% being interested in a guaranteed source of income like the annuity provides.

This disconnect isn’t a new phenomenon and was voiced by Franco Modigliani in his 1985 Nobel Prize acceptance speech, “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. It is still ill-understood.” In short, Modigliani gave voice to what economists call the annuity puzzle.

The annuity puzzle attempts to understand the gap between the theorized need for annuities amongst the general population and the number of annuities that are actually purchased. In the years since Modigliani’s speech the need for a solution to the United States’ retirement planning problem has never been greater. In 2016 MarketWatch reported that 43% of older Americans said their greatest fear about retirement was outliving their savings and investments. If an annuity can guarantee an individual won’t outlive their income in retirement then why are so few people buying them?

Part of the reason may be pushback from financial advisors who cite the high fees and complexity of annuities. The complexity of annuities is baked in from the start. Initially, there are two ways to fund an annuity: immediate and deferred. Immediate annuities begin with the investment of a lump sum, for example $100,000, with an insurance company. The insurance company will then begin to pay the buyer monthly or annually as agreed upon in the contract. A deferred annuity is a concept most people are familiar with. The buyer of the annuity agrees to invest with an insurance company for a set period of time. Once that time has been reached, let’s say ten years, the buyer has the ability to convert their investment into an immediate annuity, which allows them to begin receiving payments from the insurance company.

After an investor decides how they intend to fund their annuity they must choose whether they want a fixed or variable annuity. A fixed annuity has no risks associated with market exposure, allowing the investor to receive both their principal investment and interest in incremental payments. In fact, Kenneth Fisher, founder of Fisher Investments, known for his “I Hate Annuities… and So Should You!” campaign has admitted in an interview with ThinkAdvisor that he is okay with, “a simple (fixed) annuity that doesn’t act very differently from what you think you’d get when you’re buying a bond — a low return on investment and a simple return of your capital that’s clearly disclosed.”

Variable annuities on the other hand attempt to generate higher returns by exposing the investment to stock and bond markets, similar to a mutual fund. While this appears to be a practical solution on paper, this quality also comes with higher management and commission fees. A feature that deteriorates returns and leads some like Fisher to conclude, “almost always, anything that can be done with an annuity can be done a better way.”

Assuming an investor can accept the high fees associated with variable annuities they will then face the challenges of incorporating an annuity into their retirement plan. While annuities can provide a predictable income stream, they do not allow quick divestment in order to accommodate emergency spending needs. This can be especially concerning for retirees since a Fidelity analysis reports a couple that retired in 2016 can expect to spend over $260,000 on healthcare costs alone throughout their retirement and it is unlikely those expenses will be predictable like other costs annuities are designed to cover. Furthermore, a thorough understanding of the annuity contract is necessary if the investor intends to bequest the annuity to a surviving spouse after their passing.

It is clear a market exists for a financial instrument that can provide retirees with a predictable and guaranteed source of income. While annuities are one solution to this problem, they don’t seem to have the support of the financial advisory community in their present form. Perhaps after a simpler annuity is introduced into the market, the annuity puzzle will finally be solved.