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Retirement Annuities: A False Sense of Security

A lot of people worry about outliving their money. Commercial annuities, sold by insurance companies, promise to keep paying as long as the beneficiary lives. So it’s a good idea to buy annuities with our retirement funds, right?

I don’t think so - at least not for most people, and not right now. On this point (and quite a few others), I find myself disagreeing with the Obama administration.

Assistant Labor Secretary Phyllis C. Borzi told Bloomberg that there is “a tremendous amount of interest in the White House” in annuities and other options that could be included in 401(k) and other retirement plans to provide a guaranteed income source.

But this interest may be misplaced. Almost any retiree can use 401(k) money to purchase an annuity, even though most company retirement plans do not offer that option. The simple workaround is to roll the 401(k) money into an IRA, which can be used to purchase the annuity. Though this is fairly easy to do, not many people do it. There are good reasons why they don’t.

The biggest problem most people have in financing their retirements is not that they live too long; it is that they save too little to support the kind of retirement lifestyles they want to have. A too-small nest egg means a too small annuity payment. So most people keep their retirement money accessible, invading it more readily when they are relatively young retirees. They are then forced to adjust their spending downward as their money dwindles, but often this occurs as the retirees reach more advanced ages and become less active. Those depleted savings may mean an uncomfortable old age, but that is what can happen when people fail to save enough.

The problem is even more acute in the low-interest-rate environment we have had in recent years. Low interest rates mean lower annuity payouts, because insurance companies calculate the payments in large part based on what they can earn by conservatively investing the buyer’s initial premium.

Then there is the inflation risk. A fixed payment for many years, which is what most lifetime annuities promise, may not buy very much if we have high or even moderate inflation for a long period of time. Retirement funds that are invested in stocks or other growth-oriented assets provide an important hedge against inflation.

There also is a life expectancy gamble in purchasing an annuity. If you live a very long time, you benefit by holding an annuity that keeps paying and paying. But if you buy an annuity and then die prematurely, your heirs generally are not able to recoup the excess money you paid. There are annuities that provide a refund in cases of early death, but those contracts carry an even-smaller payout to enable the insurer to bear the cost of serving some very long-lived beneficiaries.

Finally, there is a small element of credit risk when you buy an annuity. An annuity is a promise that is no stronger than the company that makes it and the state-run insurance pools that typically back those companies. AIG, a major annuity provider, needed $180 billion in federal bailout money after the 2008 financial crisis. Would all annuity holders have been protected if AIG had been allowed to collapse as Lehman Brothers did? We will never know. But ask yourself whether you want to have most of your retirement funds tied up in another company that someday puts that question to the test.

I understand why the White House is very interested in annuities for retirement plans. It does not want people to outlive their money, especially since America still has not confronted the enormous long-range shortfall in financing the Social Security benefits we have promised. If Social Security benefits are reduced in the future, the administration wants people to have something else to fall back on.

But it cannot change the reality that we just don’t put away enough to pay for the future. We spend a fortune on medical care that helps us live much longer than our grandparents did, yet standard retirement ages have barely budged in decades, and early retirement is more common than ever.

Insurers don’t have magic printing presses in their basements to crank out the money to cover our collective shortfall. Offering annuities in our retirement plans will not close our retirement savings gap.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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