Portfolio

Why an annuity may not make you happy

B. Venkatesh | Updated on January 26, 2013 Published on January 26, 2013


On more than one occasion, I was politely asked to provide an alternative solution when I suggested individuals to buy an annuity to fund their post-retirement living. You may have similar opinion on lifetime annuity; this is a product that will pay you a fixed sum of money periodically during your lifetime. Why are individuals biased against annuity?

Consider this. You are retired and earn a fixed sum as pension, which may or may not be indexed to household inflation. Your friend, however, has to depend on the income earned on her investments to support her post-retirement living because her employer did not offer pension. Will you be satisfied with your pension? Or will you wish that you had an income like your friend’s where you depend on the vagaries of the stock market to decide how many slices of bread you have for breakfast?

If you are a typical individual, you will feel happy receiving your pension. You may reason that a stable source of income is more important during post-retirement years than earning high but volatile income. But what if your employer does not provide you pension? Will you then buy an annuity from an insurance company using the lump-sum money you receive at retirement?

Now, most of you may prefer to invest in equity and bank fixed deposits than buy an annuity. Why? When your employer offers you pension, you will most likely look at the benefits of stable income during your post-retirement life.

And that would make you feel good about receiving the pension. Importantly, your happiness will not be reduced even if a stock-bond portfolio of equivalent amount earns higher return. This is because you create what psychologist Dan Gilbert calls synthetic happiness- happiness you make when you do not get what you want (in this case, higher expected returns from stock-bond portfolio).

But when you are offered lump-sum money, the choice is on you to decide whether to create stock-bond portfolio or buy annuity or both. Now, you are likely to look at the negative features of an annuity. Why? The expected return on a stock-bond portfolio is higher. So, buying an annuity could lead to regret, especially if the stock market moves up after you purchase the annuity.

You can overcome this feeling of regret if some part of your retirement portfolio is automatically used to buy an annuity; you can use the other part to create your preferred stock-bond portfolio. The new pension system (NPS) offers such a feature. And if you are not a subscriber to the NPS, consider buying some annuity and synthesising your happiness.

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