A Good Reason to Look at Annuities

Dr. Pinar Cebar, at the American Council on Capital Formation, put out a paper early in the year encouraging greater use of annuities in the payout phase of retirement plans. The paper is available at http://www.acff.org/reports/sr-annuities0406.html. Because a significant part of this blog bewailing high costs in annuities, this report provides an opportunity to point out positives of annuities.

In writing about defined contribution retirement plans (and non-plans), the author is almost compelled to focus on the employment-based accumulation phase of retirement planning. In part this is because that phase is where the fun is, and in part it is because so few plans allow or encourage employees to leave their money in the plan. Few and far between are the sponsors who did not want to minimize involvement with former employees, and even fewer are those who want to pay for the privilege. Reduction of costs and fear of lawsuits from employees who are now former employees seem to be the basic reasons, and they are both legitimate and substantial reasons.

In addition, because the plan is about the accumulation phase, the employer/administrator has to focus on the fees between the employee and the ultimate investments, and these tend to be much higher in annuities. A non-plan environment would appear to be neutral as between annuities and other investments, but in fact is highly biased in favor of annuities because it is much, much harder to get the money needed for tax compliance from a custodial account arrangement where everything is explicit than from an annuity. This results in over-usage of annuities in situations like school districts (even setting aside the endorsed product problem) in the accumulation phase.

What Dr. Cebi's study points out is the fundamentally different issues for the participant and in the payout phase. If one has to live off of the yield from a given pool of assets, the factors that are important are very different from those that affect an employer. Specifically, the individual should be concerned about investment risk on the downside, inflation and excess (?) longevity.

This means that the tradeoffs between cost, flexibility and annuity-specific investment characteristics is fundamentally different for the payout phase. It also means that the choices to use or not to use an annuity rather than mutual funds and which annuity to buy are highly individual. The choices are completely different, for example, if you come from a long-lived family and know you are in good health rather than come from a family with a history
of lung cancer and seem to be coughing a lot lately. As a result, people at retirement ought to look carefully at annuity alternatives, and particularly those that reduce inflation and investment risks.

This does not mean that employers should be involved. Running a mutual fund-based or annuity-based retirement plan does not make one an expert in individual annuities. It also does not make one expert in the personal details and attitudes that employees ought to consider in the payout phase. At the most, the employer may want to point the participants towards the possibilities and give them starting points for information to help them make their decisions. In a plan context, or in a non-plan context of done appropriately, the employer may want to consider having a collection of names of people interested in talking to participants now receiving money from the plan or or materials offered by investment advisors of all stripes who have that interest. But not many employers will want to, or should, go beyond that.