Should Retirees Have to Buy Annuities?

If you’re worried that you don’t have enough money to last through retirement, a fixed annuity can seem like a silver bullet: In exchange for a one-time lump sum payment, an insurance company agrees to provide an income stream until you die, whenever that is. It makes so much sense, in fact, that until this past spring, the British government required retirees to use most of the retirement savings in their employer pension accounts to buy one.

Economists loved the policy, but regular people hated it. One of the biggest problems with annuities is psychological: If you live long enough, you get enough payments back to make up your lump-sum and then some; if not, you “lose money.” Insurance companies say the real point is the guaranteed income, whatever happens, but they’ve had trouble making that case broadly. In 2014, the U.K.’s government changed course. It now lets people spend their retirement accounts as they wish, and as expected, annuity sales have fallen by half. Annuities have also gotten more expensive; the amount of income you can get per year fell 4.2 percent in the last six months.

The figure below, from the Telegraph, plots the percentage of your investment you’ll get each year from an annuity purchase. The lower the return, the more expensive the annuity.

Ordinarily, when demand drops, prices fall, too. Not so for annuities, whose prices are based on interest rates (the lower the rates, the more expensive the annuities) and on actuarial tables. In order for insurance companies to guarantee income for everyone, they have to pool the risk—they need a diverse group of people of varying expected longevity. Without a government mandate, though, a diverse group won’t buy annuities.

When economists Amy Finkelstein and Jim Poterba studied the U.K. annuity market, they found (PDF) that when annuities are voluntary, only healthy people—who think they’ll live longer—buy them. Insurance companies must then adjust their actuarial tables to reflect buyers’ longer life expectancies, driving prices up so much that annuities don’t end up being a good deal for most people. The alternative—running out of money—isn’t optimal, either. This rock vs. hard place problem is precisely the sort of market imperfection that governments use to justify mandates forcing people to buy insurance.

It’s too soon to know if that’s what’s driving up prices in Britain. The Telegraph blames inertia, claiming that only the most passive buyers, who don’t shop around for the best price, still buy annuities. Passivity can be expensive: A 65-year-old Scottish woman with £500,000 ($804,070) can get from £14,800 to £16,800 a year in income, depending on from whom she buys her annuity. When most buyers are passive, insurance companies can charge a higher-than-fair rate, discouraging more price-conscious buyers.

Even at the higher prices, an annuity might be a good idea if rates stay low: It provides longevity and inflation protection. If prices increase further, however, only the healthiest and least-price-sensitive buyers will want annuities. That would put the price of income too high for most people.

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