Low or No Surprises Supports the Case for Annuities in Retirement

In a basic sense, information theory measures the level of surprise in a message.

A highly informative message will come as a complete surprise and tell you something about which you had no previous knowledge.

Sounds pretty good, right—of what use is it to be told what you already know?  Well, there are actually cases where information is not so welcome.

Public securities markets—particularly equity and derivative markets—are information rich, and the problem with this high level of information (surprises) results in high volatility.

As explained by in their extraordinary book titled Panic: The Betrayal of Capitalism by Wall Street and Washington, authors Andrew Redleaf and Richard Vigilante explain how the combination of high information and low knowledge was a large contributor to the capital market panic that occurred in 2008-2009. 

When referring to low knowledge markets, the authors are referring to the fact that large swaths of the public financial markets are driven by owners who view their securities with a high level of statistical abstraction.  In other words, they are far removed from the direct knowledge of the fundamental dynamics that are generating cash flows for the particular security, and as a result, they are more likely to run for the exits when things get tough.

So what’s the point and how does this relate to annuities?  The fact is that public securities markets are highly volatile and it is quite possible that this trend will increase.  And while high volatility may be tolerable for professional speculators, this is a terrible combination for most retail investors and especially for retirees.

Volatility is a driver of sequence of returns risk, and sequence of returns risk is a retirement killer because it contributes to longevity risk and the inability to maintain an adequate level of retirement spending.

Annuities are pretty much at the opposite end of the spectrum in terms of surprises and volatility since they turn a pool of accumulated financial assets into a stream of guaranteed lifetime income.  Instead of exposing one’s life savings to the vagaries of the capital market casino, annuities can:

• Hedge or remove volatility entirely.
• And therefore help mitigate sequence of returns risk.
• Increase the sustainability of retirement spending levels.
• And therefore help mitigate longevity risk.