Bailout

A retirement-fund paradox

By Felix Salmon

David Merkel is insightful when it comes to a huge status-quo bias in retirement funds. If we have a lump sum, we’re loathe to convert it to a guaranteed income, even when we value the guaranteed income that we do have extremely highly:

I have long been a fan of immediate annuities, particularly those that are inflation indexed, as retirement products for seniors. Yet, they do not get bought by retirees. Why? Well, insurance products are sold, not bought, typically, and when the agent sells an immediate annuity, that is his last sale on that money. They would rather sell a less suitable product that offers them another sale down the road. And, people like having flexibility with and control over their investments, even if that leads to less money for them in the long run. Annuitizing a portion of one?s lump sum lowers risk, and takes the place of investing in bonds in the asset allocation.

Most people like the reliability of their pensions, and Social Security, should it be paid, but do not seek the same thing when investing their private money.

I suspect that one of the problems here is that it’s almost impossible to tell whether or not you’re getting ripped off when you’re buying an annuity. Unless and until a vibrant and competitive market emerges in such things, you might end up buying a million-dollar lemon with substantially all of your life savings, and no one wants to do that.

I’m not sure how much the issue of having a rainy-day fund for unexpected medical costs comes into play here: at the margin it might actually be better to be on a fixed income than to have a large lump sum which could easily get eaten away by medical bills.

I do think however that people massively overestimate the returns they can get on their money, and they often dream of leaving their heirs more money than they retired with. Such dreams almost never come true, but they also never die. The question is, how much are they worth.

Full post as published by Macroprudential on January 19, 2010 (boomark / email).