Vol I, Issue 23. Quarter 3 – 2025.

In surveys retirees routinely state that they would prefer the guaranteed income of a simple annuity over holding a portfolio of assets that is subject to a loss. However, the percentage of these same people who actually purchase such an annuity is surprisingly small. This is often referred to as the Annuity puzzle.

One of the classic rationales for the Annuity puzzle is the common belief that such annuities are simply over-priced. Furthermore, many believe that they are overpriced for the simple reason that salesmen are handsomely paid to sell them, and that money has to come from someplace.

In April of 2016, then President Obama and the Department of Labor finalized a rule to curb financial conflicts of interest, with a particular focus on annuity products sold to retirees. The idea is that there is an open suspicion that financial advisors work to sell financial products to retirees that it may not be in the retiree’s best interest to buy. The implicit accusation is that they do this for the simple reason that they are handsomely paid to do so. Of course, very few financial advisors have ever stated openly that they sell products strictly for the commissions, instead of what the customers actually need.

For example, some indexed and variable annuities have historically paid upfront commissions of 5% to 7% or more. That means that when you pay $100,000 for an annuity the agent may get a check for $5,000.

The office of Senator Elizabeth Warren looked into the issue in 2016 and found that 13 of the 15 largest annuity companies in the United States provide their agents with very interesting “incentives” based on sales volume. (See their full report here: Warren.Senate.gov, 2016) The list of incentives (above the commissions) include:

• 5 days and 6 nights at the Fairmont le Chateau Frontenac in Quebec City Canada
• 4 nights and 5 days at the Wailea Beach Marriott in Maui, HI
• A Viking Ocean Cruise from Venice, Italy, to Athens, Greece
• A week-long trip to Ireland

This does not include the ever popular “Cash rewards,” listed as incentives for several other firms on that same list.

To the surprise of absolutely no one, the Trump administration repealed the rule aimed are reducing this activity. Make of that whatever you like.

Here is the issue. If you are an advisor that has one product that seems best for the client and you are comparing that to another one that may or may not be quite as good, but pays a 5% commission which one would you push? Imagine that the client has $500,000 to invest and Product A offers no commission, but is better for the client 55% of the time, while Product B pays you a $25,000 commission and will be better 45% of the time. I am sure that you will promise to only push the first product. To that response I must say politely, “Male Bovine Excrement!” (If you don’t quite know that that means, look it up.)

To be fair, this proves nothing. The client has the right to read over all of the material related to every product presented and is ultimately responsible for the selection made. But ask yourself a related question. I recently downloaded a template for a disclosure statement for a simple fixed annuity. The template was 7 pages of gobbledygook. This was before the agent or company added any product specific material. A typical disclosure statement on the simplest annuity contract in this space is easily 20 pages.

Now be honest, when was the last time you read the fine print on a 20 page contract – or any contract for that matter? Now imagine an agent working to get you to select among 5 such products. Are you really going to read through 100 pages of such material?

Here is a simpler, parallel example. The privacy statement for the website that you are currently viewing is available from our home page and is only 10 pages long. Our policy is about as simple as it can be, because we do not sell or share information with ANY third parties. I am willing to bet that you have never even looked at it. This is true even though we have no incentive to be misleading because we don’t even sell anything. How much would you trust us if you knew that we had a $25,000 incentive to sell you crap?

Here is the bottom line. Many, and probably most, financial products are designed to be “Sold” not “Bought.” In other words, they have to be designed to include an incentive for the seller. Otherwise, the product will get lost in the shuffle of endless options. I am not claiming that advisors are dishonest people, but I am claiming that they are human, and even for a fellow with a 6-figure income, a $25,000 bonus and a trip to Hawaii will have an impact on the judgement of any working person with bills to pay, and no regulation to force them to think otherwise.

How Do I Find Fair Value?

Let us take a more positive approach to the fundamental problem. Let’s think through the valuation of a lifetime annuity that pays you $1,000 per month for your remaining life, if you purchase this at the age of 60. I am going to ignore fees, riders, survivor benefits, inflation adjustments, fraud, commissions, restrictions, bankruptcy of the issuing company, taxes, etc.

Here is how you can think through a simple valuation of this instrument. Let us assume that this is “risk free” and use a discount rate of 4%, as this is roughly the current yield on 3-month Treasuries (It’s actually, 3.96% on 9/19/2026 if you want to be more precise). I am going to simplify this a bit further by looking at annual payments of $12,000 delivered in 12 monthly installments of $1,000 each.

In this setting, a payment of $12,000, one year from now has a present value of $12,000/(1.04^1) = $11,538.46. (Note that 1.04^1 means 1.04 to the first power.) The present value of that payment 2 years from now is $12,000/(1.04^2) = $11,094.67 and so on.

But wait. This payment is not really “risk free” because you only get the check if you are alive to collect it. I am going to assume that the probability of you dying prior to the start of the  next year is 1%, which is roughly true for a 60 year old man in the US. Countless death records indicate that this rate increases at a rate of about 9% per year. (See our previous post on this topic here: https://chesterchambersphd.com/logs-tell-the-story) The point is that the probability of you dying in year 2 is roughly 1% * 1.09 = 1.09%. The probability of you dying in year 3 is about 1.09% * 1.09 = 1.188% and so on.

I am going to refer to the present value of a payment times the probability that you can collect that payment as it’s “Risk-Adjusted Present Value”, or RAPV. As a result, the RAPV of that payment a year from now is a little less because it only exists if you do. Thus, it becomes $11,538.18 * 99% = $11,423.08. The corresponding value for year two falls to $10, 973.74. I am willing to extend this to the theoretical age of 110. At that point, the probability of you dying in that year is about 32%, and the risk-adjusted present value of that payment is $536.66. When I add all of these present values together I get a total of $235,074.92. Let’s be reasonable and round that to $240,000.

To be fair, you should add a “reasonable” profit margin for the firm issuing the annuity to come up with a dollar value that is “fair” in your mind. For the sake of argument, I will pick a figure of $10,000. This means that if this contract is priced at less than $250,000 it is a fair deal.

There is one small issue that you probably didn’t think about here. The people who think that they will not live very long (like me) are not going to be interested in buying this product because its value grows with your life expectancy and you have private information about what that really is. For example, you know if you are a drunk who likes to eat a dozen donuts every day and never walks further than the refrigerator. Such a person would never buy this product unless he was also rather dim-witted (which, I must admit, is entirely possible).  

On the other hand, sober vegans in good health with a family history of longevity are much more likely to be interested in buying this annuity. This is known as an “Adverse Selection” issue. This means that the people who select the annuity have reason to believe that they will live longer than the average person. The insurance company knows about this issue, and has to bump up the price of the annuity to reflect this fact of life. This makes it appear that the insurance company is being unfair to the average customer, but they are simply being prudent.

Fortunately, the valuation is not particularly sensitive to this factor. For example, if the probability of death in year 1 is 0.75% instead of 1% the RAPV rises to about $240,752.74.

This is a VERY rough model, and is not intended to be financial advice about your specific situation because you have private information about your own health. However, at least you now have a reasonable starting point to think through the value of a simple annuity contract.

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