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December 26, 2012

FINANCE COLUMN: Annuities protect people from the pitfalls of a lump sum

VALDOSTA, Ga. — Taking money over time is a tenet of my faith. I believe in God, the Cincinnati Reds and not taking money in a lump sum.

I’ve spent more than 30 years in the structured settlement business, encouraging people to take payments over time. Watching thousands of people blow through lump sum payments made me a true believer in the power of lifetime income.

As I note in my book, “Life Lessons from the Lottery: Protecting Your Money in a Scary World,” 98 percent of lottery winners ignore my advice. Thus, it is no surprise that most of them blow their money in five years or less.

The same statistic holds true for people getting money from an injury settlement, inheritance or retirement. It doesn’t make a difference if they get a $10,000 lump sum or $10 million. People blow through the money.

It makes sense, when you think about it.

People are used to having money come in every month. Managing a lump sum is a completely foreign skill. Most people don’t do it well.

One of my first clients was a young man who lost his arms and legs in an accident and lived with a motorcycle gang. He received about $3 million. If he and the motorcycle gang had gotten their hands on $3 million, they would have thrown the party to end all parties until the money was gone.

I set him up so he received $10,000 a month. Thus, they had a party every month up until he died many years later.

The psychology is like dieting.

I struggle with my weight and used to start a diet about once a month. If I start dieting but have all my favorite foods in the refrigerator, I will fall off the diet immediately. If I must drive to a store two miles away, I think about it more and sometimes don't go. If I must drive 25 miles to get fatty foods, I am far more likely to stick to the diet.

The financial analogy is that putting all your money in a savings or checking account is like having food in the refrigerator.

Putting money in a mutual fund or certificate of deposit, where it takes effort to cash it in (and sometimes penalties or tax consequences), is similar to driving to the store two miles away.

A structured settlement is like the 25-mile drive for food. You have to do a lot of work to sell it and take a huge financial hit when you do.

An immediate annuity pays income for a person’s life, just like a defined benefit pension. Although people seem to like lifetime income from a retirement plan, a Smart Money magazine article stated what I long suspected: Few people buy them on their own.

I never understood why until I read another article, called "The Annuity Puzzle," in a June 2011 edition of the New York Times.

Dr. Richard Thaler, a professor of economics and behavioral science at the University of Chicago, discussed how purchasing an immediate annuity with 401(k) retirement money, with fixed and guaranteed benefits, was a simple and less risky option than self-managing a portfolio or having the people on Wall Street do it for you. He also noted that not enough people buy annuities.

Thaler suggested that people seem to consider an annuity a “gamble” that they would live to an old age instead of realizing that “the decision to self-manage your retirement wealth is the risky one.”

As people live longer than those in previous generations, they are more likely to run out of money before they run out of time on the earth.

The biggest objection that I see to annuities is that people are afraid to tie up their money. Thaler confirmed what I long suspected: People are much better off restricting access to their money than having full access.

An annuity is just one tool, like balancing your money among a number of investments, but the key to wealth is to develop good savings and spending habits.

We have established that I am passionate about lifetime annuities.

People receiving a lump sum should be passionate, as well.

 ---

Don McNay is a columnist for The Richmond (Ky.) Register. Contact him at don@mcnay.com.

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