Here is a bit of advice that might make annuities easier to understand:
- Do not think of annuities as investments—investments are used to accumulate assets and build wealth.
- Think of annuities as insurance products—annuities are used to decumulate assets and generate guaranteed income.
While certain types of annuities can be used to build wealth, the fundamental purpose of all annuities is the asset decumulation and income generation process that was discussed in the previous section.
Framing and the Annuity Puzzle
Most economists would tell you that it is perfectly rational for an individual to annuitize the majority of their wealth. In the real world however, there are what economists refer to as behavioral obstacles to the use of annuities. In other words, many people understandably have a hard time handing over a big chunk of their life savings to an insurance company with the hope that it will somehow come back to them at some point and turn-out to be a reasonably good deal.
The problem with the behavioral hurdles is that it really is in the best interest of most people to annuitize a portion of their wealth, even if it is a bit painful to do so. The term “annuity puzzle” is used to refer to the general aversion to annuities despite the fact that they make economic sense.
“Framing” is one way to address this obstacle. Framing simply involves thinking of or picturing the annuity purchase decision from an alternative perspective. In other words, think of annuities as insurance products rather than investment products.
For example:
- Homeowner’s insurance provides us with financial protection from the catastrophic financial consequences associated with a home burning to the ground.
- Life insurance provides us with financial protection from the catastrophic financial consequences associated with the early death of a family breadwinner.
- An annuity provides us with financial protection from the catastrophic financial consequences associated with running out of money during retirement.
Only Annuities Provide Income that is Truly Guaranteed
You might be asking why it makes sense to bother with the cost and hassle related to annuities when something as simple and inexpensive as a bond can be used to create retirement income. In fact, a common refrain among annuity critics is that annuities are too expensive—particularly when compared to alternatives such as bonds, mutual funds, etc.
The simple answer is that there is a huge difference between income and guaranteed income. With annuities, you are paying for the guarantees, and the simple fact is that there are real costs associated with insurance guarantees—just like homeowner’s insurance or life insurance.
Only insurance is able to pool risks and offer the types of income guarantees associated with annuities. Much of what you are paying for with an annuity is the peace of mind that comes with any good insurance product. In the case of annuities, the peace of mind involves your retirement income.
Take Away 1: Think of annuities as insurance products rather than investments.
Take Away 2: Annuities offer income guarantees that are unique in the financial world.
Take Away 3: The insurance guarantees offered by annuities result in costs and features that are different from the world of investments, so avoid trying to make apples-to-apples comparisons of annuities and investments.
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