The Annuity Puzzle

Economists say certain annuities could help retirees live securely, free to spend money without the fear of depleting their savings.

But consumers, by and large, aren’t buying annuities for retirement.

And for a lot of economists, this is puzzling. In fact, researchers call this conundrum “the annuity puzzle,” and they think retirees will be better off if they can solve it.

The annuity puzzle is the subject of a growing body of research by economists who have been searching for more than 40 years for ways to encourage more people to buy annuities. Solving the puzzle has taken on increasing urgency in recent years with the approach of what many see as a retirement crisis.

“The annuity puzzle is just that — if you’re trying to fund your retirement, the annuity is a very efficient way to do that. And it’s puzzling why there’s not more use of commercial annuities,” Wade Pfau, author of “Safety-First Retirement Planning” and professor of retirement income at The American College of Financial Services, told Annuity.org. “People love Social Security and they love pensions, but now that they might have to build their own pension with an annuity, they seem to not want to do that as much as academics think they should.”

Potential solutions take into account both rational and emotional reasons for dismissing annuities. These range from peoples’ overestimation of their ability to manage retirement funds to the cost of annuities. Even the way annuities are explained affects how people feel about them.

In the Absence of Pensions, Retirees Need a Plan for Income

Fewer and fewer American workers entering retirement can rely on pensions to cover their expenses in their golden years. As a result, retirees find themselves responsible for managing their savings amid the uncertainty of unknown factors, not the least of which is: How long must my savings last?

One of the most daunting aspects of purchasing an annuity for consumers is relinquishing their premium in exchange for a series of future income payments. Some individuals may feel as though their money is disappearing. Despite the added income security and the logical understanding that it makes sense, parting with a significant portion of savings can be a painful experience.

I encourage retirees to prioritize their preferences using the four key criteria: Flexibility, Growth, Guarantees and Tax-Efficiency. These priorities can guide discussions and product recommendations when developing an income plan. For those who prioritize ‘Guarantees’ highly, annuities become a compelling option.

Stephen Kates, CFP®Principal Financial Analyst for Annuity.org

Stephen Kates, CFP® is a personal finance expert specializing in financial planning and education. He serves as the Principal Financial Analyst for Annuity.org, where he delves into industry trends to support consumers and financial advisors on wealth management, annuities, retirement planning, and investing.

Unintentional Transition from Pensions to Savings

Complicating matters is the fact that the transition from pensions to savings plans wasn’t a deliberate decision on policy.

“Congress never sat down and said, ‘Let’s try to change the incentives, change the law and regulations so that you’d see this shift from defined benefits to defined contribution,’” Benjamin H. Harris, A Brookings Institution economist and former U.S. Assistant Treasury Secretary for Economic Policy, told Annuity.org.

Retirement account administrators provide little guidance on how participants can turn their balances into income streams that can carry retirees through their lives, so people are left with access to a large sum of money and no long-term strategy.

“This whole transformation just happened almost by accident. It was the result of a lot of small decisions by employers. So, a lot of times, when you have these, sort of, unintentional policy shifts, things don’t work out the way you expect,” Harris said. “And that’s what happened here, which is that we have a lot of money in retirement accounts…but we don’t have a great way of transitioning all that savings into security.”

Life Expectancy: Expect to Outlive Your Savings

This transition from pensions to retirement savings accounts is happening at the same time as average lifespans are increasing overall.

On average, 45% of Americans said there is a chance they will outlive their savings, according to Northwestern Mutual’s 2023 Planning & Progress Study. And 33% said they have not taken any steps to address that fear.

That’s a realistic fear. A white paper published in June 2019 by the World Economic Forum projected that people in the United States will outlive their savings by eight to 11 years, with women bearing the greatest burden.

People ask how much money they need to save for retirement. But Harris contends that’s not a useful question.

“There’s this notion now that there’s sort of this golden number that you have to reach in order to be secure in retirement,” Harris said. “The problem with that is that having a lump sum of money doesn’t really provide you with the security you need for one simple reason, which is: People have no idea how long they’re going to live.”

This means that when you’re planning for retirement, a crucial part of the equation is unknown.

“It’s the most fundamental source of uncertainty in our life,” Harris said. “It’s a massive source of uncertainty when it comes to financial planning. There’s really no way to deal with it other than an annuity.”

In light of this logic, one would think there would be a high demand for this obvious solution. Not so.

Going at It Alone: ‘No Good Options’

In their Brookings report, Baily and Harris explain that the economic models of “rational human behavior” assume that people planning for retirement will buy annuities that give them regular, recurring income.

This would be the logical choice for someone who understands the consequences of exhausting their savings in later life, with nothing to fall back on.

“Someone at age 80, say, who runs out of money, would find it very hard to obtain a job to provide themselves with continued income. For those with health problems, it would be virtually impossible to take a job,” they wrote.

Emphasizing quality of life after retirement, Harris asserted that the alternative to an annuity is to “hoard the money and keep it in case you live into your late 90s because there’s a chance that many Americans will [live that long]. The problem with that is all the foregone spending that would make you happy in retirement. Hoarding your money and hoping you don’t live too long is a terrible way to retire.”

But this is apparently what a lot of retirees do. Wenliang Hou, a quantitative analyst at Fidelity Investments, said empirical studies show that people tend to be conservative with their retirement spending unless they face sudden expenses, such as large medical bills.

“You cut your living standard in your early years of retirement,” Hou said in an interview with Annuity.org. “That’s not what we want to see.”

The alternative is to budget your savings according to the average life expectancy, which will work for roughly half of retirees. For the other half, who will live beyond the average life expectancy, this is an impractical strategy.

Ultimately, Harris said, “there are really no good options when it comes to doing it on your own. And that’s why we need to figure out the annuity puzzle.”

Reasons People Don’t Buy Annuities

Annuities that provide a steady income were created to meet a specific need for a specific segment of the U.S. population. They are not a solution for everyone.

For example, the very wealthy don’t necessarily need to worry about stretching their savings for an indefinite period of time. At the other end, people who are poor or don’t have significant retirement savings can’t afford annuities. And Social Security is designed to replace a higher proportion of pre-retirement income for people who made less money while working.

Economist Olivia S. Mitchell of the Wharton School of the University of Pennsylvania noted that people have other forms of annuitized income, including Medicare and real estate. She told Annuity.org that the idea of the annuity puzzle is overblown because significant numbers of people won’t benefit from annuities.

Other economists see it differently.

“That still leaves a middle-class population that is quite large and has either lost or is losing traditional pensions,” said Baily.

Baily, who was chairman of the Council of Economic Advisers under President Bill Clinton, said the reasons people don’t buy traditional annuities are clear, and they have a lot to do with the way advisors frame these products.

“Number one, people feel like they’re not a good deal because they’re linked to fixed interest rates, and interest rates are very low,” Baily said. “They figure you’ll be better to put your money in equities. When I talk to financial advisors, they sort of say, ‘you’re not getting much return from investing in bonds, and an annuity is a way of investing in bonds.’ So that’s one problem.”

Some people want to leave as much of their accumulated wealth as possible to their children or other beneficiaries. This is what economists call the bequest motive.

According to Hou, the reasons people don’t buy annuities fall into one of three categories:

Ultimately, rational and psychological factors combine to perpetuate misconceptions about the intended purpose of annuities.

Psychological Factors

Economists say people’s perceptions and feelings about their money influence their decisions in ways that don’t necessarily encourage sensible retirement planning.

“I think what matters is what’s in people’s minds, how they think of their risk,” Hou said. He suggests focusing on how people rank their various retirement risks and priorities, such as health care costs and bequest motives, and trying to quantify them through behavioral economics.

Baily echoed Hou’s sentiments regarding behavioral economics and the annuity puzzle, noting the difference between peoples’ perception of retirement savings and their perception of pensions.

“A pension you think of as a fringe benefit,” Baily said. “‘My employer gave me a pension, and that’s great. I welcome that fringe benefit. But if this is my money I saved up that’s in my 401(k), do I really want to buy an annuity and hand it over to someone else to manage?’”

As Baily and Harris’s report found, peoples’ behavior often runs counter to the logic of expert predictions when the outcome of an event is uncertain. And when the topic is unpleasant or complicated, psychological factors have an even greater effect on rational decision-making.

“I think people overestimate their ability to manage money or don’t want to give up control of their money,” Baily said. “So, it’s a psychological thing as much as anything else. They don’t want to part with their funds that way. And people have trouble visualizing what it would be like to be 85 and have no money.”

Mitchell said one reason people don’t buy annuities is they don’t have experience with or exposure to the products. Thus, people are uncertain of the value of annuities and reluctant to spend a large sum of money on the chance they’ll live long.

“I call it the bus problem,” Mitchell said. “They’re afraid they’re going to buy an annuity and walk outside and get hit by a bus. The reality is you also might live to be 105 years old.”

Framing: Insurance vs. Investment

The deliberate presentation of a product or concept is referred to as framing, and it can have a significant impact on the choices people make.

Researchers have found that the words used to describe annuities ­can affect whether people see them as desirable. Specifically, when annuities are framed as investments, they are less appealing than when they are explained in terms of “consumption,” which refers to spending for the purpose of obtaining things of value.

A paper by the National Bureau of Economic Research described the difference between the consumption frame and the investment frame as:

When thinking of an annuity as an investment, a consumer considers the chances of not recouping the principal or calculates how long he or she would have to live to make it a good investment.

But that’s not the intent of income annuities. They’re designed to provide a stream of payments that will allow the consumer to spend more freely in the future. And like other forms of insurance, they protect against the possibility that something bad might happen — in this case, poverty in old age.

And, as with any form of insurance, the risk you’re protecting against may never occur. You might not get into a car accident, and yet, you still pay for car insurance.

In a survey conducted by the same team of researchers that wrote the National Bureau of Economic Research paper, people responded to questions about life annuities, with some questions presenting annuities using language that emphasized them as a way to have spending money and other questions presenting them as investments.

A total of 1,342 participants aged 50 and older responded to the internet survey, which presented respondents with a choice between a life annuity and four other savings or investment options, including savings accounts and period-certain annuities.

Respondents in the consumption-frame group overwhelmingly chose the life annuity over the other products, with 72% opting for the life annuity when told the remaining payments would go to charity upon their death.

The researchers concluded that peoples’ attitudes toward annuities matched the goals implied by the framing. Those who believed the goal of the product was to provide a return on their “investment” were more likely to choose one of the other products, focusing on factors relevant to investments, such as “illiquidity and an uncertain investment return.”

By contrast, the participants in the group that understood the goal of the product to be a guaranteed income stream that would provide guaranteed spending money every month for the rest of their lives were more likely to choose the life annuity.

Rational Factors and the Puzzle

Paschenko identified other strong factors, including:

Baily added that the cost of health care is a factor that weighs heavily in people’s decisions related to annuities.

“Long-term care insurance is very expensive,” he said. So people want to hold on to their savings in case they need to pay for nursing home care.

Annuitization Is a Key Piece of the Puzzle

To make matters worse, the concept of annuities is more complicated on the commercial market, which offers annuities to meet a variety of needs. But when it comes to the annuity puzzle, not all annuities are created equal.

The annuity puzzle focuses only on annuities that create a stream of income and can replace pensions. And in the United States, most commercially available annuities don’t meet the criteria.

“I was once talking to someone from Japan who didn’t understand why, in English, we have these two words — ‘annuity’ and ‘pension’ — because they really should mean the same thing,” said Pfau.

The evolution, complexity and variety of annuity products contribute to a fair bit of confusion surrounding them. Economists consider this a key reason for the annuity puzzle.

Annuitization is the process of converting the principal and interest from an annuity into a fixed, periodic stream of payments. But, confusingly, not all commercially purchased annuity contracts are annuitized. Legally, however, all annuity contracts must contain that option, Pfau explained.

In other words, not all annuities provide income in the form of periodic payments. In fact, surprisingly, most of them don’t. Instead, many people use annuities as tax-deferral tools and cash them out as a lump sum at the end of the contract period. Others choose to roll their annuities over or make periodic withdrawals from their annuity accounts.

“I think the reason we have that [differentiation] in American English, at least, is that annuities kind of took a sidetrack with the tax code,” Pfau said. “They evolved to be tax-deferral tools instead of income tools.”

At the same time, other prominent financial products — namely pensions and Social Security — are annuitized and meet the true definition of the word “annuity.” But the average person doesn’t think of these benefits as annuities.

Social Security: A Popular Annuity

Economists point to the popularity of Social Security as proof that income annuities can be appealing to retirees. The guaranteed income of the federal program has long been one of its most treasured features.

In an analysis for The Legislating for the Future Project, Senior Fellow William A. Galston wrote that former President Bush’s 2005 Social Security initiative “was a very hard sell politically.”

Concerned for their future standard of living, Americans opposed Bush’s proposal to implement mandatory “personal accounts,” at the expense of guaranteed benefits. According to Galston, surveys showed that in this context, “ownership and choice” were not as attractive as financial security to Americans, the majority of whom were more risk-averse following the 2001 recession.

In his analysis, Galston quoted Sen. Lindsey Graham who explained, “Ownership … is not what people look at Social Security as being. They look at Social Security as a safety net.”

In other words, people place a high value on the certainty of their monthly Social Security checks, even though they may not realize that these checks are essentially annuities.

Hou said the best annuity deal is to wait to claim Social Security for as long as possible. If you claim Social Security at age 62 instead of waiting until your full retirement age (FRA), you can expect a 30% reduction in monthly benefits. For each year you delay claiming Social Security beyond your FRA, up to age 70, you receive an 8% increase in your benefit.

Even in the context of the annuity puzzle, which centers on annuities that produce income, there are different options.

Traditional Income Annuities

Annuities with Living Benefit Riders

Indexed and variable annuities with guaranteed living benefit riders provide a payment stream and principal protection, a benefit that does not come with standard income annuities.

These annuities allow the owner access to the funds used to purchase them, often with restrictions in the early years. Indexed annuities, specifically, give buyers principal protection. This means they won’t lose their original purchase funds. The tradeoff is that, in exchange for access to the principal, the income payments are smaller.

The living benefit rider continues to provide an income stream, even after the premium is depleted.

These annuities are significantly more popular than traditional income annuities. A 2023 study by LIMRA and the Society of Actuaries Research Institute found owners of a guaranteed living withdrawal benefit (GLWB) rider had a surrender rate of just 10% in the year the surrender charge expired. That compared to 33% for those annuities without the rider.

Pfau said the emergence of deferred annuities with living benefit riders has helped to address retirees’ concerns about giving up their assets and control of their funds.

Redefining Retirement Finances: An Expert’s Insight

Retirement can be a stressful time, especially when the economy is uncertain. But there’s a financial tool called a structured annuity that could be helpful for some. With a structured annuity, you can invest your money in the stock market and still have some protection against risks. 

This means you can grow your money while also having some safety. Think of it like a financial safety net that helps you reach your financial goals. Pfau authored a 2023 white paper on how structured annuities can improve financial outcomes for households.

“Retirees don’t necessarily need the full upside of the market,” Pfau told the Annuity.org Podcast. “[Structured annuities are] giving those downside protections and then sharing in a nice, decent portion of the upside that really can lay the foundation for a more effective retirement income portfolio.”

Annuities are no longer just about shielding against losses; they’re about creating a smoother, more prosperous journey into retirement. This perspective may make annuities more appealing as part of retirement plans.

Creating a Personal Pension for the 21st Century

Researchers at the Georgetown University Center for Retirement Initiatives sought to address the annuity puzzle with a “21st-century personal pension” in a June 2022 policy report.

Source: Center for Retirement Initiatives

The authors of the report proposed four components necessary to building personal pensions: 

• A financial engine to project income needs.
• A trade-off engine to determine preferences.
• A longevity model to capture significant differences in life expectancies.
• A way to address longevity risk without relying solely on longevity insurance.

Annuities could play a pivotal role in realizing the authors’ vision of a personal pension. In the context of the proposed 21st-century retirement system, annuities can help provide a reliable and personalized income stream. Here’s how:

1. Financial Engine: Flexible annuities can provide a sustainable and predictable income stream throughout retirement by tailoring payments to individual preferences.

2. Tradeoff Engine: Annuities give you the flexibility to design your retirement income plan based on your needs. You can choose to receive a regular income to cover your essential expenses while keeping some money aside for your discretionary spending or to leave as an inheritance.

3. Longevity Model: Annuities provide guaranteed income for life, so you can be financially secure no matter how long you live.

4. Longevity Risk Mitigation: The study suggests rethinking traditional longevity insurance and considering annuities. Annuities can provide a hedge against longevity risk without completely sacrificing access to funds, aligning with both investment and longevity concerns.

In summary, annuities can be a valuable component of the proposed personal pension framework, offering a balance between guaranteed income, flexibility and risk mitigation in the dynamic landscape of retirement planning.

Solving the Puzzle

An expert panel discussion at The Brookings Institution looked at the merits of offering safe retirement income solutions as part of retirement plans in 2019.

Panelist and Senior Strategic Policy Adviser for the AARP Public Policy Institute David John noted that countries around the globe face the same threat to their retirees’ income. He referenced proposals for safeguarding retiree income in Australia, the United Kingdom, Canada and New Zealand, all of which include some sort of income solution to address longevity risk, specifically through annuities or managed payout funds or both.

According to John, to combat the complexity of making sound financial decisions with so many unknown factors — how long they will live, the direction of the economy, their health or the health of their children and spouses, possible windfalls and a host of other life events — retirees need “an automatic retirement income solution that works as well as the many automatic mechanisms available for the saver.”

Currently, 401(k) plans in the United States rarely offer annuities as an option. But there are significant changes in attitudes of workers toward annuities — and changes in the law allowing more annuity access.

A 2018 survey by Alight found 47% of employers cited fiduciary concerns as a major reason for not offering annuities as part of the plans.

However, a 2023 Allianz Life Insurance survey found 68% of employees would like more annuity information as part of their plan and 67% would consider adding an annuity if the option were available.

John recognized the resistance to annuities despite the fact that “they offer just about every feature that the consumers want” and cited a study that illustrates the annuity puzzle.

He told the audience, “There actually was at least one study where people described the properties of an annuity, and people loved it, up until the time that the ‘A’ word was used, and then they hated it at the same time.”

Economists in the United States don’t generally recommend mandating annuities for retirement accounts. But many suggest making them the default for at least a portion of 401(k) accounts, requiring workers to opt out if they don’t want them.

“A lot of people take their cue from their employers,” Harris said. If an employer doesn’t offer an annuity, “that’s one of the reasons they’re not taking them up — because it’s not implicitly suggested.”

Baily said the lack of annuities in 401(k) plans means there’s “no sort of advice system to tell people about the benefits of annuities or to draw the analogy to pensions and say, ‘This is a way that you can create your own pension.’”

Advanced Life Deferred Annuity: A Possible Solution to the Puzzle

Economists believe advanced life deferred annuities, or ALDAs, have the potential to solve the puzzle.

ALDAs, which are purchased at retirement and set to begin payments at the age of 80 or 85, allow people to keep their money after they retire at age 65 while insuring against poverty later in life.

These later-paying annuities are relatively inexpensive because of their 15- to 20-year accumulation period and the fact that, because these are life annuities, annuitants’ funds are pooled, resulting in continued payments for survivors over time as the number of recipients dwindles.

Research shows that people who have saved at least $65,000 would benefit if 10% of their retirement savings were invested in deferred annuities that begin payments at the age of 80, according to Mitchell.

“We’ve been proposing this as a way to let people keep part of their assets, but insure themselves,” said Mitchell, who is executive director of the Pension Research Council and professor at Wharton’s Business Economics and Public Policy Department.

A study co-authored by Mitchell estimated that even with low interest rates, a retiree could buy a single-life deferred annuity for $50,000 and begin receiving $17,000 to $20,000 a year for life at age 85.

The primary problem with these annuities is they’re hard to find. Annuity companies tell researchers they don’t offer them because people aren’t interested in buying them. But Baily said people don’t buy them partly because they can’t find them. “So, it kind of feeds on itself,” he said.

In addition, Baily said persuading people to buy longevity annuities is “a tough sell.” He thinks it will take several years for Americans to appreciate that they are a good kind of insurance.

But if employers offer and encourage ALDAs and word of people’s satisfaction with the product spreads, “it could become quite a popular thing,” Baily said. “But it’s a big stretch to get there.”

Baily noted that up until recently, Israel mandated annuities for retirement savings. Now that they are optional, people still buy them. “And so that sort of tells you that if you can get the thing going, then it becomes more popular,” he said.

“I think people would be better off if they purchase them, but they don’t really understand them,” Baily said. “They react to them by saying, ‘Well, but if I die when I’m 75, then I don’t get anything.’ That is, of course, true, but you don’t get anything if your house doesn’t burn down from a house insurance policy, and you still buy that.”