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I’ve spent the past third of my life observing annuities, as an annuity marketer at Vanguard, as author of Annuities for Dummies, as editor of RIJ, and as a fly-on-the-wall at dozens of annuity conferences. Over that time, I’ve developed a few personal theories about why it’s so tough to sell annuities, especially income annuities.

Here are three reasons I think annuities aren’t more popular:

Few people spend two hundred big ones all at once, on anything. Most people value liquidity highly, and the purchase of an annuity means a cliff-like loss of liquidity. No one I know pays for insurance of any kind with a lump sum; their spouses would veto the transaction. The most sensible way to buy a retirement annuity is the way you buy your Social Security benefit from Uncle Sam: With a little bit of every paycheck, over a lifetime.

“Deadstick” landings are unpopular. When an airplane loses all propulsive power and the pilot has to emergency-land onto an airstrip or highway or cornfield (or the icy Hudson River, famously) with no way to regain altitude, that’s a deadstick landing. No matter how old, many people still hope to get rich someday. And they reduce their chances if they annuitize too much of their money. They feel less powerful.

Jack Bogle is not an avid fan. Vanguard has always preached that if you stay the course (keep expenses low, don’t try to market-time, and always have a few losers in your portfolio), then reversion to the mean and the equity premium will see you safely through and you won’t need to insure your investments. If St. Jack were a cheerleader for annuities, sales would be higher.

If you’re wondering if any of my hypotheses were ever tested in double-blind studies or published in peer-reviewed journals, they weren’t. And none of them shows up in the forthcoming First Handbook of Behavioral Finance (Elsevier), edited by Douglas Bernheim, Stefano DellaVigna and David Laibson.

In the just-published draft (NBER Working Paper 24854) of a chapter in the book called “Behavioral Household Finance,” authors James Choi of Yale and John Beshears, David Laibson and Brigitte Madrian of Harvard, review the best available research on the causes of the annuity puzzle. Here are the factors they collected and shared:

‘Actuarially unfair’ annuity prices. Several studies suggest that life-only income annuities don’t offer good value. According to one estimate, the average annuity owner only gets back between 75 and 85 cents for every dollar of purchase premium, with insurance company costs eating up the difference. To me this means: most people don’t expect to live long enough to be “in the money” on their contract.

A high fraction of household wealth is already annuitized in the form of future benefits from Social Security and private pensions. This seems intuitively right. For many people, the present value of their Social Security benefit can make up more than half of their net worth. On the other hand, the fact that most people minimize their benefits by claiming ASAP makes me wonder if they understand that Social Security is an annuity.

A bequest motive plus the opportunity to invest in equities can suppress annuity demand. It makes sense, as the authors observe, that people who are primarily thinking of their children’s inheritances would prefer individual stocks over annuities, especially where the investments aren’t held in qualified accounts. On the other hand, research shows that the bequest motive is fairly weak.

Married couples have built-in partial longevity insurance. On the principle that one can often live cheaper than two, or that a surviving spouse needs less income than an elderly couple, the book suggests that “when one member dies earlier than expected, there are more resources available to help meet financial needs if the other member lives longer than expected.” This explanation seems less than intuitive, although it makes sense that the high cost of many joint-and-survivor annuities, relative to single-life annuities, might hurt their appeal to couples.

Annuities are not popular in bull markets. “Annuity take-up is negatively correlated with recent stock market returns. Households appear to extrapolate when forming beliefs about future stock returns and therefore prefer lump sums that can be invested in equities when recent returns have been high,” the book says. Conservative investments don’t hold much attraction when the world seems to be ignoring risk. A smart near-retiree, you might hope, would sell inflated equities to lock in safe lifetime income. But most people don’t think that way.

Uncertainty regarding future health care needs. “Households may refrain from purchasing annuities and instead use accumulated wealth to self-insure against the risk of health shocks,” the book says. This sentiment could be especially strongest among people who dread the prospect of needing Medicaid-funded long-term care. At the same time, anyone with a health problem that reduces longevity expectations would obviously lose interest in life annuities, unless a discounted or “impaired risk” annuity were available.

Institutional factors don’t make it easy for plan participants to buy annuities. Since 401(k) plans generally do not include education that emphasizes the importance of turning savings into retirement income, most people don’t arrive at retirement with an understanding of or appreciation for annuities–or a well-marked path toward the purchase of one. “Few defined contribution retirement savings plans provide annuities as an option in the investment menu, and small frictions in the process of purchasing an annuity may decrease annuity take-up substantially,” the book says.

Not everyone is smart enough to make a sensible annuity choice. Is it dumber to buy an annuity or not to buy an annuity? It seems to depend on the situation. On the one hand, it takes a certain amount of financial sophistication to understand and appreciate the value of an annuity. Also, smart people tend to be wealthier, and wealthier people tend to live longer, so smart wealthy people, you might think, would value longevity insurance. On the other hand, people who are financially sophisticated are often confident enough in their investing ability not to feel the need for such a conservative financial instrument.

There you have them: Eleven answers to the annuity puzzle. Eight of them are deemed worth mentioning in an authoritative new textbook. Three of them come from my gut. Sellers of annuities should feel forewarned, if not forearmed.

© 2018 RIJ Publishing LLC. All rights reserved.

The defined contribution retirement savings system in the US may be only one or two Congressional roll call votes away from a subtle but far-reaching shift in direction, philosophy and leadership.

A new paradigm called “institutionalization” may be about to glide like an Amtrak Acela into Washington, D.C.’s white marble Union Station.

Lew Minsky, the president and CEO of the Defined Contribution Institutional Investors Association (DCIIA), which advocates for the asset managers, recordkeepers and other providers of services to retirement plans and participants, used that term in a recent email with RIJ.

Institutionalization, as Minsky later described it in an interview, means a transfer of direct sponsorship of private 401(k) plans fro employers to industry players. Traditionally, each employer has required more or less its own unique Department of Labor-regulated plan from 401(k) service providers; in the future, industry players could offer one plan design to hundreds of small, mid-size or even large employers.

This shift, which current law prevents from fully flourishing, would check several boxes:

¶ Many employers say they don’t want the legal liability, cost, or administrative of offering a federally regulated retirement plan.

¶ Service providers say the shift would allow them to apply their economies of scale to every plan, no matter how small, making the whole system cheaper and more efficient. As one asset manager’s whitepaper said, it would change the retirement industry the way the mass-produced Model T changed the American auto industry.

¶ In Washington, policymakers and legislators want to boost retirement savings among the have-nots of the current system—tens of millions of low-income and minority workers whose employers don’t currently offer a plan.

Here’s an edited version of RIJ’s interview with Minsky:

RIJ: Lew, when you say ‘institutionalizing’ the retirement industry, what exactly does that mean?

Lew Minsky

Minsky: It means shifting the defined contribution model to a more institutional model. It means pooling assets, broadening the set of solutions, and closing the performance gap that exists between DC and [professionally managed] defined benefit pension funds, endowments and foundations. In the broadest sense, it means driving better outcomes for participants.

RIJ: We’re talking about institutionalizing the 401(k) for smaller companies specifically, right?

Minsky: Institutionalization involves a recognition that, at least at the small end of the employer spectrum, there’s a disconnect between the work required to set up a plan and the risk required to be a plan sponsor, on the one hand, and the capabilities and capacities of small and ‘micro’ employers.

RIJ: Can you give me an example?

Minsky: For instance, DCIIA itself is a small business. And we’re already in the retirement business. So we should be well positioned to run a small plan. But it’s a lot of work for a small employer like us. So we participate in a multiple employer plan, or MEP. We’re in the American Bar Association’s plan. We feel like that’s the best solution for us. But the requirements—the nexus [or ‘commonality’] required to be in a MEP like ours requirements—are very limiting, however. We support opening that up.

RIJ: So, today an association and employer like the American Bar Association or the National Association of Auto Dealers can sponsor a MEP. But, under some of the legislation pending in Congress, a retirement plan service provider would be able sponsor a MEP… is that right?

Minsky: It’s an open question as to who would be the sponsoring employer of these plans. I expect we’ll see a solution evolve that looks more like Australia’s system. In Australia, they have superannuation plans or supers. They have disintermediated the employer through the sponsorship of trusts. The employer would make mandatory contributions for employees. Clearly, it will be an uphill climb to require mandatory employer contributions in the US. But it’s a discussion that we’ll eventually have to have. I haven’t found an economist yet who thinks that we can close the coverage gap without at least a ‘soft nudge’ in that direction.

RIJ: Who would be most likely to sponsor a multiple employer plan here in the US?

Minsky: Companies with built-in distribution models, particularly those with strong retail brands, will find it attractive to sponsor these programs. Others that are less well-positioned to sell directly to employers will look to be solution providers.

RIJ: You mentioned disintermediation. What will all this mean for the financial advisors, like members of the National Association of Insurance and Financial Advisors, who currently put together 401(k) plans for small employers?

Minsky: I don’t think the members of NAIFA should be concerned. We’re looking to make the pie bigger. It can work to the benefit of everyone—especially for the individual worker. I’m sure we’ll see a multi-faceted system develop, along the lines of 529 plans. There will be institutional distribution options as well as options for brokers to sell plans to their clients and earn commissions.

RIJ: Some say that institutionalization will help close the so-called coverage gap by encouraging and enabling more small employers to offer 401(k) plans for the first time. But others tell me that institutions will likely sell multiple employer plans to companies that currently offer plans. They’re an easier sell, but aggregating existing plans won’t narrow the coverage gap.

Minsky: Some of this will evolve organically. I expect to see a combination of approaches. Leading providers and others will have opportunities to recruit new employers that have been left out of the system because the challenge was too daunting before. We’ll also see a model where existing plans get an option to upgrade. If, as an employer, I already have a plan through ‘recordkeeper X,’ and that recordkeeper develops its own MEP, I might be able to get the same services I had before at a lower cost. For other companies, institutionalization will be an opportunity to refine their model—i.e., step up their game in the face of competition.

RIJ: What’s the likelihood that institutionalization will actually happen?

Minsky: Whether it’s through RESA [the Retirement Enhancement and Savings Act of 2018], or through industry ingenuity, we are ultimately going to see an expansion of pooling arrangements. As a system, we have to provide a model that’s easier for small employers to offer plans. The mix of providers who are serving plans will change a bit. It will become more institutionally-focused on the investment side and more retail-focused in terms of outreach to individuals. But, in the long run, to make meaningful societal changes with respect to retirement savings, we’ll have to think about policy and decide if we’re willing to introduce a soft mandate.

RIJ: Thank you, Lew.

© 2018 RIJ Publishing LLC. All rights reserved.