Income annuity puzzle: Why don’t more people use them?

Financial planner Michael Kitces thinks a hybrid income annuity/long-term care insurance policy could be the solution to a riddle economists have puzzled over for years.

Economists have long argued that there’s a perfect financial product for retirement: the humble immediate income annuity.
It’s a straightforward proposition: Fork over a big chunk of cash to an insurance company, which starts sending a monthly check when you retire – or later. The cash keeps coming as long as you live.

The immediate annuity, which also goes by the name of single premium income annuity (SPIA), offers effective protection against longevity risk, which is the risk of outliving your money. It comes with an intriguing special sauce, euphemistically known as the “mortality credit.” That simply means insurance companies use the unpaid assets of folks who die at younger ages to pay out to those who live longer, and it allows an annuity to have comparatively high payout rates.

But economists also talk about an “annuity puzzle.” Namely, if SPIAS are such a perfect retirement vehicle, why do so few people buy them? Sales totaled $7.7 billion last year, according to LIMRA, the insurance industry research and consulting group. That’s a drop in the bucket compared with IRAs and workplace retirement plans, where $5.3 trillion were invested last year, according to the Investment Company Institute.

One oft-heard response to the annuity puzzle is that retirees fear a SPIA won’t pay off if they don’t live very long. Another big objection is the loss of liquidity associated with an annuity purchase. What happens if you get really ill, or lightning cracks your roof in half?

Now, that fear is getting a close look in a study by two economists, who attempted to quantify what happens to the value of an immediate annuity when an unexpected health shock occurs. Their conclusion: health shocks can produce a unique double-whammy for annuity buyers: a sharp decline in life expectancy, which cuts the remaining value of the annuity, and the unmet need for cash to pay for care. They conclude that for risk-averse retirees, or for those with limited retirement assets, the best move is to avoid annuities altogether.

Learn more at Reuters Money.