Monday, April 23, 2012

Reader question about annuities (SPIAs)

First off, you may notice that I'm in the process of renaming my blog. What once was "Pensions, Retirement Planning, and Economics Blog" is now "Retirement Researcher Blog." The new name is shorter, and I hope it is more to the point, especially as I never seem to discuss other economics topics anyway.

Here is a question I received through email followed by a brief answer:
 
My own thinking has always been that if an insurance company can take my $100K and guarantee me an inflation adjusted return of $X, through good markets and bad, for 20 to 40 years, and in addition make enough more to cover expenses and turn a profit, then I should be able to do the same thing.  Do they have access to investments that I don't? I don't believe so.  Am I wrong?

They don't have any special investments which you don't have. But what insurance companies can do is pool together many people and have a pretty good idea about the overall age of death distribution for that group. After accounting for their overhead charges, this allows them to pay you at a rate you could use if you were to live to about your remaining life expectancy at the time of purchase.  Since you don't know how long you will live, you may probably need to plan for an extra long life so you don't run out of wealth. That means spending less than otherwise. For the insurance company, people who die sooner end up subsidizing payments to people who live extra long.  SPIAs provide insurance against outliving your wealth. That is what is special about them and why they can make these promises over such a long time period.

I think that's the basic answer for your question. There are a lot of complex things out there called annuities, but I think SPIAs are relatively straightforward and innocent. I'm still working on research about the role of partial annuitization, so I will be coming back to this topic again with more details. There is
an unseen fee with SPIAs called an overhead charge, which is how much less your payout rate is than what would be the fair amount for their pool of customers based on everyone's life expectancy. But the insurance company is providing a service to you, and that is the charge for their service.