Annuities Underutilized by Investors, Study Says

A recent academic study suggests that investors rely too little on annuities, given that annuities can guarantee retirees an income that lasts the rest of their lives, and at a lower cost than it would take to achieve that goal using investment products like stocks and bonds.

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The study, by Professors David Babbel of the Wharton School and Craig Merrill of the Marriott School of Management at Brigham Young University, calculated that people should use roughly 75% of their excess wealth—that is, the wealth they have beyond what they need to provide for their basic needs—to buy annuities, assuming normal stock market volatility and risk premiums and a 10% markup on annuities.

Mr. Babbel said that conclusion contrasts with reports in the financial press suggesting investors should put 25% to 30% of their savings into an annuity.

The study was co-sponsored by the Wharton Financial Institutions Center and New York Life Insurance.

As fewer companies provide workers with defined-benefit pension plans, and as Social Security replaces a smaller portion of workers’ pre-retirement income, there is increased interest in the methods workers should use to draw upon their retirement savings in order to avoid running out of money.

Mr. Babbel and Mr. Merrill argue that annuities are the best method for guaranteeing that retirement income will last as long as the retiree does.

The study notes that life annuities pool longevity risk among all of an insurance company’s annuitants. “To achieve a similar riskless guarantee of income [in another way] throughout one’s uncertain lifetime would cost between 25% and 40% more,” Mr. Babbel and Mr. Merrill wrote.

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They also noted that income annuities are getting cheaper. While an earlier study found that in 1995, the price markup on annuities sold to retail investors ranged from 6% to 10%, “we find that today, eleven years later, the markups on nominal annuities have dropped to about half those levels, and that fixed real annuities reflect a markup of only 2%,” Mr. Babbel and Mr. Merrill wrote.

Mr. Babbel said the decline in annuity markups reflects both the more rigorous pricing model used in the study and the increased competition among annuity providers.

Source: financialweek.com 08-13-2007

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