Three Problems With Annuities – And How To Fix Them
July 7, 2018 by Elizabeth Bauer
So let’s start with a disclaimer: I am an actuary, but I don’t have professional experience with annuities as offered by life insurance companies, and I’m more than willing to stand corrected by such professionals.
What’s the big deal with employers closing their pension plans and moving employees into defined contribution plans instead? Partly it’s that employers provided these benefits to all employees unconditionally, that is, except for vesting requirements, whereas the typical 401(k) contribution, as it’s evolved today, requires employees to kick in their own money to get the employer match (though some employers do still provide unconditional contributions, and there’s nothing inherent in the Defined Contribution plan that requires the matching contribution structure). Partly it’s a matter of apparent or actual cuts in retirement spending: people who look at the full-career benefit in a traditional plan vs. a projected 401(k) equivalent will see seemingly-deep benefit cuts that aren’t apples-and-oranges because frequent job-changers are often better off with a 401(k) than a traditional pension, but there is also a real drop in spending, where the employer spending in a 401(k) plan might more closely resemble what employers would have expected to spend in pension funding a couple decades ago with higher expectations for investment returns and lower expected life expectancy.
But the larger issue, and a real loss in the switch away from traditional pensions, is that employers had been acting as annuity providers to their employees, and were providing their services at very inexpensive rates.* The key benefits that traditional pensions provided — protecting workers against investment risk and against longevity risk — are available for the asking, in the form of immediate or deferred annuities. It’s just they’re so danged expensive that they’re (nearly) uniformly considered to be a terrible means of investing one’s money.**
But I think it’s useful to step back and ask, why are annuities so expensive? Three big reasons.
First, the problem of anti-selection. It’s the reverse of what happens with life insurance, where insurers will require you to take a medical exam because they know that people with a diagnosed medical condition will be more eager to purchase life insurance, and lots of it. Quite the opposite happens with annuities — because people in poor health are not nearly so worried about outliving their savings and much less likely to buy annuities, actuaries have to price annuity rates based on very high life expectancy assumptions, which discourages anyone of poor or even average health from considering them.
Second, insurers providing guarantees for fixed payouts, month after month in retirement, do so by investing conservatively. There’s a real cost to providing these guarantees. Insurance companies can’t go out and back their annuities with hedge funds or private equity or even just an ordinary stock portfolio, because, unlike an employer, they can’t count on boosting their reserves with revenue from their “regular” lines of business; for insurers, this is their business.
And third, the very nature of the individual annuity market means that there are heavy marketing and administrative expenses.
And each of these costs is something that traditional pension-providing employers don’t face, or at least not to the same degree.
They provide the same pension benefit formula to all of their employees, so they benefit from a mix of healthy and sickly retirees. They are not bound to the same sort of reserves as an insurer would be, since they are obliged to make up for any investment losses with revenues from the company, so they can invest as aggressively as they wish. And they have economies of scale, because they do not need to “sell” pensions to their employees. Ironically, employers are now discovering that in many cases, it can be more affordable for them to purchase group annuities for their retirees than to administer the benefits themselves, because of the first and the third of these advantages.
So can we fix these problems to make annuities more attractive to individual retirees, and restore their lost investment and longevity risk protection?
With respect to anti-selection, my pet solution is as simple as the pop-up ads claiming to forecast how long you’ll live. In the same way as insurers use medical exams to place prospective life insurance purchasers into rate classes, I’d love to see them come up with rate classes for annuities, in which they offer more favorable conversion factors for individuals who are, based on quantifiable and objective measures, in poor health, so that they can get a good value for their money. To be sure, it might be difficult to create a system where customers can’t cheat, but if there were a significant payoff, in terms of being able to offer a more attractive product for sickly retirees, it might be worthwhile.
With respect to the cost of guarantees, that’s a bit trickier. I’d love to see more flexibility available to insurers, and others willing to dive into the market (including the folks who are right now managing our 401(k)s) to provide benefits which provide partial guarantees in exchange for more investment flexibility and, hopefully, higher returns. One model is the “Collective Defined Contribution” plan in The Netherlands (see here for a description), in which plans provide lifetime benefits with a built-in cost-of-living adjustment but if returns are poor the COLA may be temporarily dropped or, if that’s not sufficient, benefits may be cut.
And the marketing and administrative expenses are the trickiest yet. Obviously, the more prevalent annuities are, the less marketing is needed, and the lower the administrative costs per customer, but getting from here to there is not easy. To be honest, the only good solution I see here is to model a tax credit off the hybrid tax credits, which were temporary credits meant to phase out after a given model reached a specified volume. How prevalent would annuities need to become for consumers to know enough about the product going in, that they wouldn’t need as much marketing? I couldn’t begin to say, but surely it’s a calculatable (or estimatable) figure.
Would these steps make annuities more attractive by being a better value for the money? Would consumers prefer having their money available to them as a lump sum regardless? That’s an issue for another day.
What do you think? Tell me at JaneTheActuary.com!
*I’d say, “for free” except that the overall cost of the plan, including plan expenses, would have been taken into account in terms of compensation budget and “paid for” by reduced cash compensation, but until recently employers weren’t talking about the cost of the risks they were taking on.
**Fun fact: It’s actually fairly common in Europe for employers to fund their pensions by means of purchasing deferred annuities to avoid risk. Once I had to explain to an auditor that my client’s assets for their Dutch pension plan were in the form of deferred annuity contracts, promising a fixed benefit at retirement, so the client couldn’t produce an asset statement: “Yes, it’s like what your grandfather might have bought.”
