Annuities: A Love Hate Relationship
Retirees cherish the monthly lifetime income provided by traditional pension plans and Social Security yet remain hesitant to convert their retirement account balances to monthly annuity payments. What’s behind this apparent contradiction?
Defined Benefit and Social Security Affection
Traditional defined benefit (“DB”) pension plans are a beautiful thing – or perhaps I should say ‘were’, given their significant decline in prevalence over recent decades. Traditional pension plans were remarkably effective in helping create retirement security for nearly a century’s worth of retirees. When I speak with retirees who have a DB pension, they often refer to themselves as among the lucky ones and they say it with a self-assured sense of security and satisfaction.
Similarly, Social Security is held near and dear by retirees and those approaching retirement. This is no surprise, as Social Security is in essence a defined benefit plan, in that the benefit earned is expressed and paid as a monthly lifetime annuity during retirement.
Given how retirees feel about their DB and Social Security benefits — and the success of these programs in reducing poverty among the elderly and providing income security for tens of millions of retirees – it certainly seems fair to state that traditional DB style pension benefits are a beautiful thing.
Annuity Purchase Hesitancy
[Note: References to ‘annuity’ throughout this piece pertain to a Single Premium Immediate Annuity, whereby the retiree pays a single lump sum premium to an insurance company in exchange for fixed lifetime monthly payments starting immediately and with no benefits payable after death. Many other types of annuity products exist such as deferred, indexed and variable annuities, some of which might also include pre-retirement withdrawal options and death benefits features. These various other types of annuities are not addressed in this piece.]
With the shift from defined benefit to defined contribution (“DC) plans (such as 401(k)’s), many retirees now face the dilemma of how to invest and spend their retirement accounts over their lifetime. In turn, they run the risk of either overspending or underspending, or investing too conservatively or too aggressively, while having to always be mindful of the ultimate risk of running out of money prematurely.
In concept, annuities directly address these challenges in that they shift the longevity risk (the risk of outliving available funds), and the investment risk and responsibility, from the individual to the provider. Just like good old DB plans! Yet despite growing interest among retirees in guaranteed income and annuities, few are choosing, at least so far, to convert their retirement funds to an immediate annuity. Why the reluctance?