The Economic Role of Annuities

by Michael J. Boskin, B. Douglas Bernheim, and Patrick J. Bayer, A Catalyst Institute Research Project

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Catalyst Institute Press Release

SUMMARY

Annuity contracts are unique saving vehicles that provide a framework for managing both the accumulation and the payout phases of an investment. In their simplest form, annuities guarantee, in exchange for an initial capital payment, a periodic payout for the remainder of an annuity owner's life.

Under current law, all annuity contracts -- both qualified and nonqualified -- allow the investor to defer taxes on earnings credited under the contract. Qualified annuities (e.g., annuity contracts purchased through a 401(k) or 403(b) pension plan or an individual retirement account) also allow the deferral of income taxes on principal invested in the annuity. Consequently, investments through annuities generally provide higher after-tax rates of return than do investments made outside of annuities.

Sales of qualified and nonqualified annuity contracts have grown rapidly over the past 10 years, outpacing the sales growth of other financial products such as mutual funds and life insurance. This trend is largely attributable to provisions that allow earnings within an annuity account to accumulate tax-free. Thus, the elimination of these tax provisions would be expected to lead to a significant decrease in the demand for annuities and a corresponding decline in the nation's saving rate.

A decline in the United States' saving rate is highly undesirable -- especially at this time. U.S. households currently save relatively little, by both historical and international standards. The net national saving rate in the United States has fallen from an historical average of more than 9 percent of gross domestic product in the 1960s and 1970s to an average of less than 5 percent in the 1980s and 1990s. This substantial decline in the saving rate has made the financing of investment more difficult and has contributed to reductions in the growth of productivity, wages, and household income in the United States.

The importance of saving and of maintaining an environment that supports a wide variety of market-driven saving and insurance vehicles will grow in the years ahead, due largely to increases in life expectancy. The fastest-growing segment of the population will be the elderly and, among them, the very old.

The economic implications of this transition will be far-reaching. The two largest government programs that provide for the elderly, social security and medicare hospital insurance, have serious long-run actuarial problems, with projected benefits exceeding projected receipts by trillions of dollars. Unless changes are made in these programs soon, the tax increases and/or benefit cuts necessary to bring these systems into balance will be wrenching.

A major contributor to the low saving rate in the United States is the present tax system, which favors current consumption and debt at the expense of saving. Therefore, efforts to reverse the historical decline in saving must include government policies designed to encourage increased retirement savings. Annuities provide a particularly appropriate focus for such policies.

Policymakers should consider more tax incentives to encourage savings. Certainly, opportunities for tax deferral through annuities should be continued, as their elimination would fly in the face of efforts to stimulate saving. Tax-deferred annuities provide investors with powerful incentives to save.