The War Over Annuities with “Living Benefits” Continues

Variable annuity sales sagged after the 2000 stock market crash. They were restored after the industry developed “living benefits.” There are different versions, but they generally guarantee the account owner a minimum rate of return or lifetime income in return for higher fees. The annuities have their advocates and detractors, and they continue to fight with words and numbers. The latest missive from the detractors is from Wade Pfau on the web site AdvisorPerspectives.com. Pfau’s conclusion is the annuity guarantees are expensive and not likely to deliver enough security to be worth the cost. He also is concerned that most investors overvalue the guarantees because they don’t adequately consider the effects of inflation on long-term income.

But do these products provide guarantees of any real value to their users? I won’t attempt to evaluate the actuarially fair cost for the GLWB guarantee to determine if they are over- or underpriced. Others have done important work in that area, such as Advisor Perspectives’ analysis and a rather heated discussion with Morningstar that ensued. I acknowledge such disagreements about the actuarial value of the guarantees, and that such products’ values are difficult to objectively quantify.

Those issues aside, I remain concerned that prospective retirees may be overvaluing the guarantees in their mind because they are not properly considering how inflation will erode their real value over time. In behavioral economics, this bias is known as money illusion. People can logically understand the effects of inflation, but their emotional responses and decisions remain attached to nominal values.