Tim Harford on Annuities

Tim Harford asks--but does not answer--one of my favorite questions: why are we so scared of annuities (link)? And the corollary question: why is that the market for annuities in this country just stinks? Tim does mention that "insurers must fear that only vegan teetotalers will buy them"--aka, the problem of adverse selection. But virtually every insurance product has some kind of adverse selection problem; it's not obviously worse with annuities than with other products. It's also true that the prices for annuities are high (or, translated, the returns are low), but they aren't entirely irrational, and they probably would come down if the market were better developed. Granted, the Brits had some bad experience with annuities a few years back, but that can't be the reason: most Americans don't know anything about the British experience--and god knows we have had more than our share of problems with the much-beloved corporate defined-benefit pension scheme (think LTV, think airline pilots--hey, go back 50 years and think Studebaker).

I don't have an answer, but I am fascinated by one particular pivot point in the annuity puzzle. Say you're 65 and you have been lucky enough to save a million dollars. You're afraid of "outliving your money." You could buy an annuity that would guarantee you payments for life, no matter how long you might live. Granted it is high price, and granted there is the risk that the insurance company itself will go broke. But I don't think that is what really bugs people. What bugs them is that they might pay out a million today and die tomorrow. "I want," they always say, "to leave something for my kids."

Well of course you do, wonderbuns, but you also want not to be dependent on your kids when you're 85, and you want your kids not to have to take care of you. Isn't that something?

I'm still not very far down the road of figuring out the answer, but I do have a partial suggetion for what to do with that million at age 65: buy an annuity that kicks in at age 85--i.e., depend on your own assets for the first 20 years, but insure the long tail. I don't know what it will cost you, but it won't cost you as much as a full annuity starting tomorrow. That way, if you get lucky and die at 71 (that's a joke, son), your kids will have something. They stand to lose altogether only when they've really lost out already.

Think of it as just another kind of high-deductible insurance, and if you have read this far, you probably know what that is already: you buy collision insurance on your new car, but you agree to pay the first $1,000, or $2,500, or even $10,000 yourself. Or think "catastrophe insurance" in health care: you agree to pay your own daily medical expenses, but you buy coverage against the major loss. Once you start thinking of an annuity as insurance--and treating it that way--then all your problems are over. Glad you asked?