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By Christine Benz | 02-22-2013 09:00 AM

Reasons Retirees Avoid Annuities

Vanguard's John Ameriks says annuities carry much value, but real-world issues and other disincentives make the products undesirable for many retirees.

Christine Benz: Hi, I'm Christine Benz for I recently attended the Morningstar Ibbotson Conference and had the chance to sit down with John Ameriks, who focuses on retirement research for Vanguard. We discussed the role of annuities and why many retirees tend to be resistant to buying them.

John, thank you so much for being here.

John Ameriks: I'm happy to be here, Christine. Good to see you.

Benz: You are going to be talking today about the role of annuities in retiree portfolios, and there has been a lot of academic research pointing to annuities being additive to retirees' long-term plans. Let's talk about that data and why so many academics tend to be positive on the role of, say, a single premium immediate annuity?

Ameriks: Sure. I mean, I'd be happy to do that. We'll put it in the context of the broader problem that retirees are trying to solve when they retire. In most academic models, so to get to the theory thing right upfront, in most academic models, the baseline assumption is someone who is saving cares about their future spending. That's why they save because they want to spend at some point in the future, and they are forward-looking when they're doing that.

If you make those assumptions and a bunch of other mathematical assumptions, essentially you will get a pattern of wealth accumulation that looks like a triangle. People build wealth up during the accumulation phase, and they should be spending it down during the decumulation phase.

In most of those models there is no scope or room for the value of assets that are left behind right? If someone dies prematurely and hasn't spent assets, in a sense, they are wasted. It produces no value for them. That's a very important aspect of why annuities in such a framework add so much value. Because what annuities do essentially that insurance product is a pooling arrangement, where a group of people get together, put all their money in a common investment and basically will say, "Look, those of us that survive, will continue to take the average amount of supportable payments out of the pool; while those of us that die will not make a claim on the residual assets in the pool."

You can kind of see immediately if I talk about it like that, that leaves assets in the pool that can be paid out to people who live longer. So, in a sense, if all you care about is the maximum amount of spending over your lifetime, an annuity can add a lot of value because it shifts assets from a state that you don't care about them in, because you're gone, to a state in which you do. And that is why in most models, when you run math, if you got a risk-averse individual, an annuity can add a lot of value. There are lots of other assumptions, though, in the real world that push back on that very basic framework, and I'd love to talk to you about those, too.

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