Arnold Kling  

Inappropriate Annuities

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Are annuities appropriate for the elderly? The Securities and Exchange Commission and the National Association of Securities Dealers say not necessarily.


The SEC also today issued an alert to remind investors that variable annuities are not suitable for all consumers, especially investors who need the money in the short term or who borrow against their home mortgage in order to purchase a variable annuity or variable life insurance product.

The Washington Post story on the SEC/NASD report has this quote.

"We've seen a lot of sales to the elderly, and your money is tied up for so long that it can create real issues for people who need it for health care," said Mary Schapiro, vice chairman of NASD, the main self-regulatory body for brokers. "We want to get ahead of the issue."

This sounds like what I wrote here, except that I was talking about Social Security, arguing against Peter Diamond's view that Social Security makes up for the failure of seniors to annuitize enough of their income.

I doubt that elderly people who maintain their assets in lump sum format rather than as annuities are as irrational as Diamond and others suggest. In the real world, the elderly face many more sources of uncertainty than just their date of death. For most other sources of uncertainty, a lump sum provides better protection than an annuity.

For example, take the risk of a sudden jump in expenses, due to a medical problem or other crisis. If you have a lump sum, you can handle the spike in cash needs without having to take out a loan.

So, on the one hand the government forces senior citizens to annuitize their income through Social Security. On the other hand, it accuses the private sector of being too aggressive in marketing annuities and that annuities are not necessarily appropriate for all seniors.

For Discussion. Peter Diamond argued that seniors should annuitize more of their income, and that Social Security is a good thing because it forces them to do so. The SEC/NASD report says that seniors should not necessarily annuitize their income. Can those two positions be reconciled?


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CATEGORIES: Social Security



COMMENTS (9 to date)
Boonton writes:

Reconciliation is actually quite easy. Since receiving SSI benefits is basically an annuity, most people already have a heavy position in annuities. It would be hard to argue that they need more. IF SSI was abolished or altered beyond all recognition then there probably would be a need for seniors to look at annuities again.

rvman writes:

This isn't all or nothing. That most seniors should annuitize more than they would without SS, but, given SS, seniors shouldn't annuitize all or most of their non-SS residual, are not competing statements.

Let's say the typical senior would annuitize 25%, but a few would annuitize more. If SS forces them to annuitize 40%, and optimal is 50%, SS is a good thing, by the rather paternalistic logic both the SEC and Mr. Diamond are using. The SEC is saying that some firms are getting seniors to annuitize, say, 80-100%, which the SEC thinks, in their paternalistic wisdom, is too much. That doesn't mean the SEC thinks SS should go away, or that its "annuity" form is bad.

rvman writes:

I'm obviously agreeing with Boonton, not arguing - our posts crossed.

Lawrance George Lux writes:

Annuities are a good thing for Seniors, as it impels normal Consumer behavior. Seniors should take out loans to pay for serious medical bills, while keeping the majority of the assets intact, exactly like younger families buy houses with mortgages. The long-term view must insist Seniors keep a Assets matrix for the entire length of their life. lgl

Brad Hutchings writes:

Psychology plays as big a role as econimics in determining the right financial vehicles for older people. If an older person would drop $5K on something frivilous when they can't afford to just because they convince themselves they can afford to do it and really need it... an annuity is a hell of a lot better situation than having the money easily available.

Arnold asked recently what a good career direction is for people just graduating from school now... Become a financial advisor who can evaluate the financial situation and psychology of older people and get them and their families into financial vehicles that match what they really need. There will be a growth market in families outsourcing "no, grandma, you cannot afford that" to people who are trained to stare down grandma.

Jim Glass writes:

I think this discussion may be paying too much attention to the theoretical concept of "annuity" and too little to the practical reality of "very bad investment" that the SEC is warning about.

These are not lifetime or long-term annuities for the most part, most run just a few years and are sold on the promise of being tax shelters -- a promise that is bogus these days and very expensive to investors in them.

One upon a time variable annuities made sense for a selected market: people who had maxed out their tax-deferred retirement accounts and had additional funds they wanted to invest on a tax-deferred basis. A variable annuity is like a nondeductible IRA without the $2,000 (then) contribution limit -- tax deferral allows pre-tax compounding of investment earnings which is finally taxed at ordinary rates when cashed out. So if your other retirement accounts were maxed one was the logical next step.

Fees were high and you couldn't cheaply liquidate one prematurely -- though you could get ones with very short terms -- but those weren't problems for people in those circumstances who wanted the tax-deferred compounding.

Today though these annuities make sense for just about *nobody*. Variable annutities typically invest in stocks and mutual funds -- and with capital gains and dividends both now tax-favored all a variable annuity does is double the tax rate one would pay on the same investments if held in a taxable acccount, for a steep fee.

But this hasn't kept these damn bank and brokerage commissioned salesmen from pushing them all over the place as tax shelters because of that tax deferral.

I recently had a professional encounter with somebody who had bought one for his IRA of all things -- how dumbass can one be? Paying a big commission to buy a tax-deferred investment for an account that was already tax-deferred. And of course the market had plunged since he bought it, so he had a loss he couldn't deduct in the tax-deferred account if he cashed the annuity to get out of it. With every penny left over after the loss being fully taxable at ordinary rates when it comes out of the IRA.

Of course he was pushed into it by a bank salesman who got a whopping fat commission. When he realized what he'd done he asked, What can I do? Nothing -- except run in the opposite direction as fast as you can the next time someone offers to sell you a bridge before you feel an irresistable urge to buy it.

This kind of wide shilling of what is just a plain awful investment for most people is what the SEC is warning about, the length of the terms of the annuities involved is the least of it.

Dave Sheridan writes:

I agree with Boonton and Jim Glass. On the investment side, you have forced annuitization of $X, which is either higher or lower than an individual's "optimal" amount. "Optimal," though has a preference component to it -- the aversion to risk of not having liquidity to pay for unforseen expenses. On top of that, an individual's overall tax and estate planning situation enters into the mix. Given the right information, (including the investor's comfort level) it's a straightforward exercise in asset allocation. Good financial planners will understand and explain the options and their implications to their customers, and will not recommend investments that don't make sense.

I'd argue for stronger enforcement actions against unscrupulous sales practices under "know your customer" rules. Too many salesmen, dressed up as financial planners, are greedy, ignorant or both. But let's not let paternalism take perfectly legitimate investment vehicles away from the people where they truly fit.

Andrew B writes:

I think Diamond and the SEC are looking at different issues. Variable annuities are essentially an investment product, and relatively few are held after retirement to protect against longevity risk. I believe the SEC's warnings are against aspects of variable annuities that don't touch on Diamond's general argument that people should annuitize a greater share of their retirement savings.

Ian Callum writes:

Congress should strip variable annuities of their tax advantage, as their so-called "insurance" feature is primarily a sham.

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