The Biggest Threat to Annuity Investors

Annuities are one of the most hotly debated products in the financial world. Many financial planners believe their costs make them unusable in any situation, while many others point out their tax benefits and unique characteristics that help reduce the longevity risk of outliving your assets. In fact, many policymakers have suggested that putting more of your retirement assets into immediate annuities would help avoid the risks involved in stock market volatility and other pitfalls of having to invest your own retirement nest egg.

Yet a recent study (link opens PDF) from researchers at the Congressional Budget Office and the National Bureau of Economic Research concludes that for many individuals, real-life challenges make putting too much of your assets in immediate annuities a risky mistake. Let's take a closer look at the study and other historical research on this important question.

The state of the annuity market
For nearly half a century, many annuity advocates have relied on a groundbreaking research study from the 1960s. This study argued that anyone who didn't want to leave money to future generations would do best to invest in annuities rather than alternative investments.

Yet annuities aren't nearly as popular as that early study suggests they should be. In light of tepid sales and annuity-guarantee risks taken on during the financial crisis, annuity sellers MetLife (NYSE: MET  ) and Manulife Financial (NYSE: MFC  ) have taken substantial steps in recent years to revamp their annuity businesses, cutting benefits in some cases and limiting sales in others. Hartford Financial (NYSE: HIG  ) and Aegon's (NYSE: AEG  ) Transamerica unit last year sought to pay annuity owners either to modify their contracts or to purchase them outright.

Why haven't annuities been more popular among investors? The CBO study attempts to explain the reason for the disconnect between the 1960s study's predictions and financial reality.

Having a safety net
The idea behind the original 1960s annuity study was simple. Assuming no costs, annuities pay more than regular fixed-income investments because they include what's known as a mortality credit, which comes from those who die before their life expectancy and therefore forfeit a portion of their original investment in the annuity.

But in its attempt to explain why so few investors actually buy immediate annuities, the CBO study critically assessed the earlier study's assumptions. For one thing, annuities are far from costless, with most charging fairly substantial fees to cover mortality risk and other expenses.

More importantly, though, the 1960s study didn't allow for the possibility that health problems would shorten life expectancies and create immediate cash needs. If you've annuitized your entire life savings, then an illness or injury could leave you in an untenable financial situation, as you no longer have access to your original investment principal and can only draw from the monthly payments the annuities gives you.

Moreover, if an injury or illness reduces your life expectancy, then the value of your annuity falls dramatically. Even in a world where you can buy or sell annuity contracts freely on an open market at any time, immediate annuities can't handle the risks of unexpected health problems.

Why age matters
The CBO study doesn't argue that annuities are never warranted for anyone. For those who are rich enough for annuity payments to cover even unexpectedly large health costs, annuities still make sense. On the other hand, the more risk-averse you are, the less you should generally annuitize.

Moreover, age plays an important role in the annuity decision. The older you are, the more advantage an annuity has over regular fixed-income investments due to the mortality credit. Yet the risks of health problems also rise with age. The study found that the sweet spot for annuities falls roughly in your 50s, when annuities start to pay a higher mortality credit but the risk of bad health news is still relatively low. By your 60s and 70s, on the other hand, the incidence of negative health surprises overwhelms any benefit of the mortality credit, and only once you reach your late 80s or 90s does the mortality-credit factor take precedence. In other words, for many of those who have just retired, the timing is bad for annuitizing your wealth.

Interestingly, the CBO research comes to the conclusion that younger households would actually do best if they could sell annuities short. By doing so, they'd essentially be betting against their own health, and the paper suggests that if they later suffered an illness or injury that reduced their life expectancy, they could then buy an immediate annuity much more cheaply. In the real world, there's no mechanism for short-selling an annuity, and an annuity tailored specifically for someone whose life expectancy is below average isn't the easiest to obtain, either.

Being smart
Even with more realistic assumptions, the CBO study still doesn't reflect reality for many families. In particular, the study's conclusions apply to those who don't wish to leave money to future generations, instead expecting to spend down their entire wealth during their lifetime.

For annuity sellers, the interesting takeaway of the study is that annuities could look more attractive if a broader range of products were available. Given the tendency of the insurance industry to provide ever-evolving new products, the net result of the CBO study could be annuities that are better tailored to retirees' overall needs.

For those who don't need the pure stability of annuitized income, your best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

Tune in to for Dan's regular columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.

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