Classical economic theory says that retirees should prefer annuities over investing in stocks and bonds. But they don't. Why? An earlier post reviewed one explanation, citing a study that said classical theory overlooks how health shocks reduce lifespans and impose burdensome costs. This post reviews other studies offering a second explanation. It examines how retirees think when deciding whether to buy an annuity.
Over-Simplifying a Complex Decision
In 2014, Jeffrey R. Brown, A. Kapteyn, E. F. P. Luttmer, and O. S. Mitchell, published a study that examined decisions to buy steady, lifelong annuity payments or to take a one-time, lump-sum payment. They noted that much of the research about such decisions "assumes a rational and fully informed individual who knows ... mortality rates, market returns, inflation, future expenditures, and income, and who can use this knowledge to optimally choose the mix of financial products to smooth" one's future budget over many years. That's a tall order, even for the brightest among us. Most of us may compensate, according to the study, by over-simplifying the decision.
To conduct the study, Brown and his colleagues generated realistic but hypothetical choices between annuities and lump-sum payments, and presented the choices to 2,112 individuals. The data indicated that most participants in the study used "simple heuristics rather than full optimization." The tendency to simplify the decision was strongest for those who had low scores on financial literacy and numerical ability, and those with less education.
A very common method of simplification, even among the more shrewd participants, was to buy an annuity or to trade one for a lump sum only when it was "an exceptionally good deal." While it might seem rational to insist on a good deal, the typical price-points in the study were extreme. On average, the participants were willing to buy an annuity only if the price was marked down by about 75% from the amount they would accept when trading an annuity for a lump sum. That's like offering to buy a new home for $60,000 but, as the owner of the same house, refusing to accept any offer below $250,000. A modest difference between the offer and list prices might make sense, but at values this extreme, a rational sale at fair value won't happen. In short, annuity buyers may have expectations that preclude reasonably priced transactions.
To conduct the study, Brown and his colleagues generated realistic but hypothetical choices between annuities and lump-sum payments, and presented the choices to 2,112 individuals. The data indicated that most participants in the study used "simple heuristics rather than full optimization." The tendency to simplify the decision was strongest for those who had low scores on financial literacy and numerical ability, and those with less education.
A very common method of simplification, even among the more shrewd participants, was to buy an annuity or to trade one for a lump sum only when it was "an exceptionally good deal." While it might seem rational to insist on a good deal, the typical price-points in the study were extreme. On average, the participants were willing to buy an annuity only if the price was marked down by about 75% from the amount they would accept when trading an annuity for a lump sum. That's like offering to buy a new home for $60,000 but, as the owner of the same house, refusing to accept any offer below $250,000. A modest difference between the offer and list prices might make sense, but at values this extreme, a rational sale at fair value won't happen. In short, annuity buyers may have expectations that preclude reasonably priced transactions.
Miscalculating the Risks
Another recent study offers a systematic explanation of the decision process that may guide annuity buyers. Under review for possible publication in an academic journal, the study is by Daniel Gottleib. Using a mathematical model from behavioral economics called Prospect Theory, the study analyzed consumers' decisions to buy or avoid either an annuity or life insurance. Logically, annuities and life insurance are complementary. One pays if you die; the other, if you live. As Gottleib argues, a theory that explains why retirees buy fewer or smaller annuities than is optimal (which they do) may also explain why the same retirees buy more life insurance than is reasonable (which they also do).
Setting aside the sophisticated math of Prospect Theory, one of its core ideas, as Gottleib explains, is that "individuals are risk averse over gains and risk seeking over losses." This means that decisions are based on miscalculation of the true risks. Here are some plain-language examples:
Setting aside the sophisticated math of Prospect Theory, one of its core ideas, as Gottleib explains, is that "individuals are risk averse over gains and risk seeking over losses." This means that decisions are based on miscalculation of the true risks. Here are some plain-language examples:
- Consumers (retirees and younger individuals alike) avoid taking losses. If, for example, they own a stock listed below what they paid for it, they avoid selling the stock at a loss and instead hold onto it, hoping that the price may recover. In doing so, they risk an even greater loss. For an annuity, the irrevocable decision to buy one may seem like a loss, if the buyer worries about dying before receiving enough payments to recoup the original cost. Just as the owner of a losing stock will hold onto it at risk, potential annuity-buyers hold onto their cash at the risk of depleting it, should they live longer than expected.
- Consumers are also over-eager to take gains. Stock-owners who have a modest gain, for example, may be inclined to sell pre-emptively and not let their profits run. They are averse to the risk that modest gains might vanish. Similarly, one who has held an annuity long enough to receive payments equal to the original purchase price may be reluctant to buy more annuities, even when doing so might be optimal. Logically, for example, it might be wise to increase an annuity if inflation has eroded the value of the original payments or if the buyer's good health has boosted the odds of a very long life. But such wisdom is atypical for retirees.
Are Better Decisions Possible?
The foregoing studies imply that when thinking about annuities, we are prone to over-simplify complex decisions and to miscalculate the true risks. Are there ways to counteract these misguided tendencies? Other research suggests that there are, and that better informed choices may be possible. That's the subject of Part 3 in this series.
For step-by-step methods to evaluate whether an annuity would be right for you, including methods to find a good insurance company that sells annuities, read our article on annuities for retirees.
For step-by-step methods to evaluate whether an annuity would be right for you, including methods to find a good insurance company that sells annuities, read our article on annuities for retirees.
Disclaimer: Historical data cannot guarantee future results. Although a mixture of bonds, stocks, and other investments may be safer than investing exclusively in one class of assets, diversification cannot guarantee a positive return. Losses are always possible with any investment strategy. Nothing here is intended as an endorsement, offer, or solicitation for any particular investment, security, firm, or type of insurance. You are responsible for your own investment decisions. Please read our full disclosures and Fiduciary Oath.
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