Annuities are great, in principle, but not so much when government policy keeps interest rates low.
Forbes post, “Do You Get Your Money’s Worth From Buying An Annuity?”
Originally published at Forbes.com on July 8, 2021.
Once upon a time, in the (somewhat mythical) past of traditional defined benefit pensions, your employer protected you from the risk of outliving your money in retirement, by acting, more or less, as an insurance company providing an annuity. With that benefit receding into the past, many experts have been hoping that Americans with 401(k) plans would avail themselves of annuities on their own, to give themselves the same sort of protection, and, indeed, the SECURE Act of 2019 made it easier for those plans to offer their participants an annuity choice, and, when surveyed, 73% of those participants said they would “consider” an annuity at retirement.
At the same time, though, Americans distrust annuities — in part because traditional deferred annuities had high fees and expenses and only made sense in an era predating IRAs and 401(k)s, when they were attractive solely due to the limited tax-advantaged options for retirement savings. But that’s not the only reason — annuities, quite frankly, aren’t cheap.
How do you quantify the value of an annuity? In one respect, it’s subjective and personal: do you judge yourself to be in good health, or does family history and your list of medications say that you’ll be one of those with the early deaths that longer-lived annuity-purchasers are counting on? Do you want to be sure you can maintain your standard of living throughout your retirement, or do you figure that you won’t really care one way or another if you have to cut down expenses once you’re among the “old-old”?
But measuring the value of annuities, generally speaking, does tell us whether consumers are getting a fair deal from their purchases, and here, a recent working paper by two economists, James Poterba and Adam Solomon, “Discount Rates, Mortality Projections, and Money’s Worth Calculations for US Individual Annuities,” lends some insight.
Here’s some good news: using the costs of actual annuities available for consumers to purchase in June 2020, and comparing them to bond rates which were similar to the investment portfolios those insurance companies hold, the authors calculated “money’s worth ratios” that show that, for annuities purchased immediately at retirement, the value of the annuities was between 92% – 94% (give-or-take, depending on type) of its cost. That means that the value of the insurance protection is a comparatively modest 6 – 8% of the total investment.
But there’s a catch — or, rather, two of them.
In the first place, the authors calculate their ratios based on a standard mortality table for annuity purchasers — which makes sense if the goal is to judge the “fairness” of an annuity for the healthy retirees most likely to purchase one. But this doesn’t tell us whether an annuity is a smart purchase for someone who thinks of themselves as being in comparatively poorer health, or with a spottier family health history, and folks in these categories would benefit considerably from analysis that’s targeted at them, that evaluates, realistically, whether annuities are the right call and whether their prediction of their life expectancy is likely to be right or wrong.
In the second place, the 92% – 94% money’s worth calculation is based on the typical investment portfolio of insurance companies, approximated by the returns of BBB-rated bonds. This measures whether the annuity is “fair” or not, in that “moral” sense of whether the perception that the company is “cheating” is customers is real (it’s not).
But these interest rates are very low. The authors, in addition to their calculations of “money’s worth,” back into the implied discount rate from the annuity costs themselves. For men aged 65, that interest rate is 2.16%; for women aged 65, 2.18%.
Now, imagine that you compare this annuity to an alternative plan of investing your money in the stock market, earning 7% annual returns, and believing you can predict your death date (or not really caring if you fall short or end up with leftover money for heirs). The cost of the protection offered by the annuity, the guarantee that you will never run out of money, and that you will not suffer from a market crash, is very expensive indeed — when you compare apples to oranges in this manner, the money’s worth ratio is, according to my very rough estimates, more like 60%, meaning that about 40% of your cash is spent to purchase the “insurance protection” of the annuity.
And, again, that’s not because insurance companies are cheating anyone; that’s solely because of the wide gap between corporate bond rates and expected returns when investing in the stock market— a gap which was particularly wide in the summer of 2020 when this study was competed, but remains nearly as wide now. As it stands, Moody’s Baa rates are in the 3% range; in the 2000s, they were in the 6% range, and in the 1990s, from 7% – 9%. Although this drop in bond rates is good news for American homebuyers because this marches in tandem with mortgage rates, it makes it far harder for retirees to manage their finances in ways that protect them from the risks that they face in their retirement.
Perhaps interest rates in general, and bond rates specifically, will increase as we leave our current economic challenges, but there’s no certainty, and as long as this gap between bond rates and expected stock market returns remains so substantial, retirees will be challenged to find any sort of safe investment that makes sense for them. Which means that what seems like a great benefit for Americans looking to borrow money — for mortgages, car loans, credit cards — can pit the elderly against the young in a generational “us vs. them” contest.
December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.
Forbes post, “It’s ‘America Saves Week’ – Should You Have A Savings Account?”
Originally published at Forbes.com on February 25, 2020.
It’s America Saves Week, an initiative to, yes, promote savings. Yesterday’s theme was “save automatically” and today’s theme is “save with a plan.” A variety of banks and community groups are on board with promoting savings.
But — can we be honest about something?
I’m so old that . . .
when I got my first “grown-up” bank accounts, after leaving grad school and the university credit union, we were persuaded to get a separate savings account, in addition to the checking account, with the lure of a higher interest rate.
You laugh, but it was true. I even looked it up in our old financial records.
The interest rate on that first bank statement was 1.60% for the checking account, and 2.81% for the savings account.
In our most recent bank statement, the savings account likewise earns more interest than the checking account, four times as much, in fact.
Yes, the savings account earns 0.04% and the checking account, 0.01%.
Now, to be sure, we bank at a large national bank, and enjoy the conveniences it offers. Higher rates still exist on online banks, but, of course, without the convenience. And even smaller “neighborhood” banks don’t offer a magic formula for higher rates: to take a few local examples, offering rates of 0.01%, 0.05%, or 0.15%.
Now, at the same time, our first mortgage had an interest rate, if I remember correctly, of 8.5%. The current rate at Quicken Loans is 3.625% for a 30 year fixed mortgage. That’s made monthly payments far more affordable for homebuyers. And this is all a part of a larger macroeconomic picture.
Beyond which, of course, savvy savers don’t leave their money in a savings account, but move it to investments of one sort or another, whether directly in the stock market, or in bonds, or mutual funds or the like, leaving in their bank accounts only as much cash as seems necessary for liquidity purposes.
But traditional savings accounts have long been a sort of “training wheels” for saving and investing, a way not just to build up a balance but build up that intuitive recognition that accounts grow with interest. (Folks, when I wrote about the importance of paying off debt before building retirement savings balances, round about this time last year, some of my twitter followers engaged in a discussion about investing, and many of them struggled with concepts around compound interest.)
And, in fact, a recent survey found that 45% of respondents said they have no money in a savings account — but in that same survey, when asked where they save (that is, “store most of their savings”), only 29% said they had no savings at all, 33% used a savings account, and the rest gave answers such as saving directly within their checking account.
So is there a reason to maintain a separate “savings” account even in these days of low interest, or even to have multiple such accounts for different purposes?
The concept of “mental accounting” says yes — or, rather, maybe. It’s intuitively easier to save (whether for a specific objective or just generally for emergency/rainy-day purposes) if the money leaves your checking account for a separate bucket. Financial advice site NerdWallet’s Amber Murakami-Fester even recommends two separate funds, one for general rainy-day needs (e.g., a home repair bill) and the other for more serious emergencies such as a job loss.
“Many people throw extra money into a single savings account and pull from it whenever their checking account balance runs low, [financial planner James] Kinney says.
“[Financial planner Laura] Scharr-Bykowsky calls this the ‘savings blob.’
“’It doesn’t really have a purpose,” she says. “You just dip into it whenever. . . .’
“When real emergencies strike, your general savings account may prove insufficient. You might then turn to expensive ways of borrowing money, such as credit cards or home equity lines of credit.
“Separating savings into buckets of rainy day funds and an emergency fund has an additional benefit: You’ll be far less likely to tap those reserves for purposes other than what they’re meant for.
“That’s due to a phenomenon in behavioral economics called mental accounting, Scharr-Bykowsky says. People tend to stop spending on one category when they know the money in that bucket is gone, even if other funds are available. Making clear savings categories for future expenses means you’ll hesitate before using the medical expense fund on a new phone.”
(At the same time, however, mental accounting has a downside, as explained in Richard Thaler’s book behavioral economics Nudge:
“The sanctity of these accounts can lead to seemingly bizarre behavior, such as simultaneously borrowing and lending at very different rates. David Gross and Nick Souleles found that the typical household in their sample had more than $5,000 in liquid assets (typically in savings accounts earning less than 5 percent a year) and nearly $3,000 in credit card balances, carrying a typical interest rate of 18 percent or more.”)
What it boils down to is this: saving for the future — for retirement, for a rainy day, for a goal of whatever sort — is still important. But with the loss of meaningful interest earnings on ordinary savings accounts, we’ve lost what was once a very useful tailwind in the effort to boost savings.
December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.