We have looked at the difference between taking risk (investing) and managing risk (insurance). We also saw how the Talmudic portfolio is a form of risk-managed investing, and that, beyond asset allocation, diversification within each asset class (“distributing portions”) further manages risk. Another tool investors may utilize to manage risk is an annuity.
Annuities are often marketed by investment professionals, but they are insurance products, meaning to say they normally come with a guarantee. There are many different kinds of annuities, and this is not the place to sort them all out; moreover, many of these products are sold more than they are bought, and come with high fees. Yet in economic theory, and often enough in actual practice, annuities may play a highly constructive role for consumers seeking to manage risk.
What risk do they manage? Think of them as the opposite of life insurance (which really should be called death insurance, but was likely given a positive spin for marketing purposes). Whereas life insurance pays a benefit upon the insured’s death, that is to say, it manages the risk that a family’s breadwinner prematurely dies, an annuity manages the risk that the beneficiary will live; in other words, it manages longevity risk.
This could be very comforting to someone of moderate means who retires at 65, but fears he may live until 95. How would he pay for all of the expenses of life for three decades without working?
As we will see in the next chapter, public pensions, such as Social Security, are failing, and private savings are woefully inadequate. Social Security is an annuity. It pays a benefit up until the time you die. A consumer therefore can take a portion of his savings and give it to an insurance company, which will provide an income stream (specified in the annuity contract) for the rest of the insured’s life. If he lives long, he will have received more than he paid to the insurance company. If he dies young, the insurance company has profited.
Consumers are often reluctant to purchase annuities because of a desire to bequeath their wealth to heirs. However, the goals of supplementary income and bequests needn’t be seen as a conflict. One can annuitize a portion of one’s portfolio. Those whose wealth can last 30 years need not purchase an annuity at all. Those of little means probably cannot afford one.
(The income you receive is proportionate to the amount of money you hand over to the insurance company, adjusted based on underwriting. Just as a smoker is not seen as a good risk for life insurers, a person in tip-top health would be a poor risk for an annuity provider.)
In effect this means that these products are out of reach for those who would most benefit from them. For that reason, we note here one (of a great many) types of annuities that might be the most relevant (and affordable) in managing longevity risk, and that is a deferred income annuity. The key word is “deferred.” Instead of handing over a chunk of your savings and then collecting monthly payments immediately, the payments are preset to begin when you reach an advanced age. Deferring the start date squeezes a lot of the cost of the pension and can also increase the benefit received because it shortens the term of payments and only kicks in at a time when life expectancy is greatly reduced.
Such a product could be a perfect solution to the problem discussed in the next chapter of adult children whose aging parents lack the means of supporting themselves. The children can step in to purchase the deferred income annuity, possibly even spreading out the payments over many years prior to the payout phase. If the parent lives a long life, the two generations’ retirements need not be in conflict.
A professional acquaintance, who happens to be an economist, reported he did just that for his mother when she was in her late 80s. He said his siblings initially questioned the wisdom of the idea, but no longer did so since, at the time he related this, she was already 96.
One final point about insurance: We have already noted that investment thinking (taking risk) and insurance thinking (reducing risk) are different. This may suggest that the approach that works in the former can be counterproductive in the latter.
When it comes to investing, paying less is generally a key to smart decision-making. That’s why investors pay such close attention to various ratios such as price-to-earnings, price-to-book or price-to-sales. The ratio is essentially telling us how much we are paying for a unit of equity, with the idea being that spending $10 for a unit of earnings is better than spending $20 for that same unit of earnings. Similarly, investors pay a lot of attention to expense ratios, preferring to pay as little as possible for the management of their money.
But it is facile to think that being a savvy consumer means getting the best price when it comes to insurance. How often have you, or someone else you know, expressed frustration that when you finally needed your insurance company, it found some reason not to pay the claim? We pay premiums so that, if we bear a loss, the insurer will make us whole. That means that, above all, we should not be looking for the lowest premiums but at the company’s financial stability and its record of paying claims.