CBO Paper Says Don’t Buy Annuities

CBO Paper Says Don’t Buy Annuities

It seems there’s been a lot of news recently around annuities. The latest is a working paper published by Felix Reichling of the Congressional Budget Office and Kent Smetters of the University of Pennsylvania’s Wharton School. It concludes that most people should not buy annuities. This is a controversial finding that is bound to spark significant debate within the financial services community.

The annuity model is simple: you give up a portion of your savings in exchange for a guaranteed stream of payments for the remainder of your life. Gil Weinreich, Editor-in-Chief of ThinkAdvisor, an online and print publication family for financial advisors, interviewed Smetters to find out why he believes that’s not a good idea. He quotes Smetters as stating that “the average American should probably not annuitize any of their wealth. Younger people should not. Even most people at retirement should not.” Smetters explains that it is in fact uninsured health care shocks – the most common being disability while working or the need for long term care while retired – that impact the value of annuities more than anything else.

Here’s the logic. Say you develop a medical condition requiring long term care, for which you are not insured. If you had previously purchased an annuity, it would not be much help, since you now have the need for a lot more income than the annuity had been designed to produce. You could sell your annuity – there is a secondary market for this – but because of your medical condition, the expectation of your longevity will have been reduced. As a result, the amount of cash you can get for the annuity will be consequently lower since its value is based on the expectation of its future cash flows. That’s just the opposite of what you need during such a situation.

Smetters goes so far as to recommend that younger people actually short annuities. How do you do that? Through life insurance. “You can get a negative annuity by buying life insurance. It is well known … that whereas an annuity pays me for living, life insurance pays me for dying. What happens when I get sick is that my life insurance increases in value. You can cash that out and get protection against uninsured expenses.”

Is there anyone who would benefit from an annuity? According to Smetters, “Those who should buy annuities have already incurred health costs or are quite elderly.” Why? Since there’s a higher likelihood they’ll die sooner, the insurance company can afford to offer them annuities with larger payments.

Most advisors think of annuities as low-risk investments. But as Smetters points out, they are actually higher-risk because they fail at exactly the times you need them the most: during health care shocks. The better alternative, according to him, is long-term care insurance for older people and disability insurance for younger people.

Personally I believe that annuities – particularly single premium immediate annuities or SPIAs – can be a valuable part of a well-diversified investment portfolio. But Smetters and Reichling suggest that they should be utilized sparingly until you reach an age where the payments become significant.

Here’s a link to the CBO working paper: http://www.cbo.gov/sites/default/files/cbofiles/attachments/44374_MortalityProbabilities-Reichling_2_0.pdf

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