“The wise man puts all his eggs in one basket and watches the basket.”
Imagine this situation. You’re a 65 year old male, and you need to get an annual income which represents 6% of your overall assets in order to live. You want to retire, so working more isn’t an option. Neither is buying a bunch of lottery tickets and trying to strike it big, no matter how tempting that may seem. You are going to get Social Security, which will cover 2% of the required 6%, leaving you 4% to cover. How do you solve this problem?
Dr. Wade Pfau, CFA, has been tackling this issue and recently published a paper covering his findings. I was fortunate enough to interview him and talk about his paper. You can find the interview in the video at the end of this article, and my U.S. News & World Report article summarizes the key points of the interview.
The headline is that Dr. Pfau’s research shows that investing in a stock/single premium immediate annuity (SPIA) mix significantly outperforms stock/bond asset allocations. You can read more about his findings in both his paper and in the U.S. News article. What I want to discuss in this post is that knee-jerk “ugh” gut reaction when you think about giving up a large portion of your assets for an annuity.
Why Monkey Brain Can’t Solve the Annuity Puzzle
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If you’re a subscriber to my 52 week personal finance game plan, you may have seen my article titled “Is Annuitization Underrated.” If you haven’t received it yet, be patient, for it’s coming. If you’re not a subscriber, what are you waiting for? Click here to subscribe…it’s free! So, either you already know my views on annuities, or, once you subscribe, you’ll discover them. I’m a supporter of single premium immediate annuities.
Let me take a step back and explain a concept here. Annuities are where you pay an annuity provider a sum of money in exchange for a lifetime income stream. There are variants to annuities, but in this post, I’m going to cover the one that Dr. Pfau investigated, the single premium fixed annuity (SPIA). In a SPIA, you hand over a one-time payment and then you receive a check every month until you die, or if you buy a joint annuity, until you or your spouse is the last to die.
Annuities are different from bonds in two key aspects. First, with a bond, you get the principal back at the end of the duration of the bond. So, if you buy a 30 year bond, you’ll get monthly payments for 30 years, and then you get your original investment back. If interest rates are at 3%, and you pay $10,000 for a 30 year bond, then you’ll get $25 a month for 30 years and at the end of 30 years, you’ll get your $10,000 back. With a SPIA, you make an initial investment, but you don’t get your investment back as principal at the end of your life. The annuity provider gets to keep it.
The second difference is in the interest rate. Annuity providers pool risks across a broad pool of buyers. For example, a 65 year old is going to have an average life expectancy of 17 years. Some 65 year olds will die sooner and some will die later. The annuity provider uses actuarial risk to determine how much to pay out, given that some people will receive only a few payouts, and some people will receive decades of payouts. Because the risk is pooled, the annuity provider can pay a higher interest rate. Bondholders do not share risk. Every bondholder will get payments for the duration of the bond, no more, no less.
Therefore, economically, when you need to meet income requirements to prevent you from suffering from bag lady syndrome, it makes sense to convert assets to annuities, because that provides the highest level of “risk free” income. You’re shifting market risk – how much you’ll get in return for your investments – to temporal risks – whether or not you will outlive the average person your age.
If annuities are such a great deal, why don’t people jump all over them? It’s what economists call the annuity puzzle.
The biggest reason that people aren’t willing to buy annuities is the perception of a loss of control over their assets. As Cornell’s Justin Kruger and David Dunning discovered – a discovery which would be eponymously named the Dunning-Kruger effect – people tend to hold a higher view of their own capability than reality would indicate. Because of these overinflated self-assessments, people assume that they can invest better than they really can, and Monkey Brain takes over to make them think that the returns of an annuity are paltry compared to what Monkey Brain can make when allowed to take over the family’s investment strategies.
Another reason that Monkey Brain doesn’t let you solve the annuity puzzle is because of a psychological bias called loss aversion. It turns out that we experience more pain when we lose something than we experience pleasure when we gain something. Losing a dollar creates more pain than earning a dollar creates pleasure. When you buy an annuity, there is no loss. It’s an actuarially fair trade (minus expenses) of money for a stream of payments. But, Monkey Brain isn’t content to simply let that trade happen without throwing a banana or three.
Monkey Brain creates a perception of loss by asking “what if.” He poses a simple question. “What if you buy an annuity and then die the next day? What are you going to do then, master?” he taunts.
Your instinctive answer is to think “well, aw, shucks, I shouldn’t have bought that annuity. I’m going to regret it,” which is exactly what Monkey Brain wants you to believe. The truth is that you’re going to be dead. You’re going to be dancing with angels or reincarnated or whatever you believe, but, even though I’ve not been to the other side to see what’s going on, I can assure you that the afterlife does not involve you regretting buying that annuity. It’s a mental trick that Monkey Brain is playing on you to get you to think about loss aversion.
What’s the right asset allocation for you in your life situation at this time? I don’t know. That’s what a detailed financial planning process is for. What I do know is that based on Dr. Pfau’s research, if you want to maximize your returns, you should be investing in annuities at retirement rather than bonds. Monkey Brain might pitch a temper tantrum, but the data is pretty convincing that it’s a really good option.
Below is the full interview with Dr. Pfau. Enjoy!
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