Framing the Options
In the study, the authors surveyed 1,342 participants and asked them to evaluate decisions made by hypothetical retirees. The retirees were said to have "made permanent decisions on how to spend a portion of their money in retirement ... each person has some savings and can spend $1,000 each month from social security." Participants were told about the decisions that two such retirees had made and were asked which of the two had made a better choice.
For example, in one comparison, "Mr. Red" made a decision that allowed him to "spend $650 each month for as long as he lives in addition to social security. When he dies, there will be no more payments." He was compared to "Mr. Gray [who] invests $100,000 in an account which earns a 4% interest rate. He can withdraw some or all of the invested money at any time. When he dies, he may leave any remaining money to charity." Given this choice, most participants said Mr. Gray had made the better decision.
However, in another comparison, Mr. Red was the same, but Mr. Gray was described differently. He was able to "choose an amount to spend each month in addition to social security. How long his money lasts depends on how much he spends. If he spends only $400 per month, he has money for as long as he lives. When he dies, he may leave the remainder to charity. If he spends $650 per month, he has money only until age 85. He can spend down faster or slower than each of these options." In this case, most participants said Mr. Red had made the better decision.
Although described differently, these two cases were mathematically equivalent. In both of them, Mr. Red had a lifetime annuity, and Mr. Gray had a savings account earning 4% interest. When the savings account was characterized as in investment (the first case) it was favored over an annuity. However, when the savings account was characterized in terms of the spending pattern it would foster (the second case), it was disfavored.
The study was well designed in a manner that systematically compared a simple lifetime annuity to several other options, including interest-bearing investments and more complex annuities like the ones insurance companies may pitch to skeptical buyers. In every case, the simple lifetime annuity was logically and mathematically the better choice, but it was favored by the participants only when framed in language that clearly stated how each option would affect the retiree's budget and lifelong spending.
Thus, looking at budgets and spending led to better decisions than looking at investment factors such as interest rates and earnings. Focusing on budgets and spending counteracted people's tendencies, described in the previous post in this series, to over-simplify and to miscalculate risks.
Making a Good Decision
- Consider your future health costs (for the reasons described in the first post). If you have excellent health insurance, such as a strong Medigap policy and long-term care insurance, then a simple annuity may be a reasonable way to smooth and stabilize your retirement income. If not, then you may be wise to set aside a reserve fund before purchasing an annuity.
- Lay out your retirement income and budget without an annuity. Then consider whether purchasing an annuity might improve your lifetime spending. Do this instead of focusing on interest rates, investment returns, or payback periods.