The Annuity Puzzle

Economists and investment professionals have long struggled with the “annuity puzzle” – the quandary as to why retirees who would clearly benefit from annuitizing a portion of their savings so rarely do so.  A new paper slated for publication next month in the Journal of Economic Perspectives by three leading academics offers ideas as to why income annuities are less popular than economists expect them to be based upon their benefits and what might be done to change it. A preview of their working paper can be found on the Center for Behavioral Finance’s website, whose director Shlomo Benartzi wrote the paper with Richard Thaler and Alessandro Previtero.

The authors frame the issue by using Franco Modigliani’s challenge from his Nobel Prize lecture: “It is a well known fact that annuity contracts, other than in the form of group insurance through pension systems, are extremely rare. Why this should be so is a subject of considerable current interest. It is still ill-understood.” That statement is as true today as it was in when it was delivered in 1985. 

Americans are retiring earlier and saving less than they were in 1985 and life expectancies have continued to expand.  These trends are inconsistent with the general reluctance to annuitize by the public at large, even though that same public generally loves Social Security and loves defined benefit pensions (if they are lucky enough still to have one).  Indeed, the paper cites the pioneering research of Menachem Yaari on the economics of annuities showing that a rational actor (with no legacy goals) should convert all his or her assets to an income annuity at retirement.

Other cited research shows that individuals with non-negligible financial assets gain substantially from annuitization and refutes supposed explanations for consumer reluctance to purchase them, including fees, price or inflation concerns. Moreover, the lack of income annuities adds layers of complexity to the financial lives of retirees. “Households who choose not to annuitize must learn a new skill, namely calculating the optimal drawdown rate over time. Given the complexity of this optimization problem, it is not surprising that retirees might err, either by under- or over-spend­ing.” The paper also shows retirees tend to under-spend in retirement, a problem that annuitization can ease, particularly since income annuities save 25-40 percent over private annuitization efforts on account of the benefits of risk pooling.

The paper makes a very strong case that greater reliance on income annuities would enable retirees to increase consumption, deal with uncertainty, and help them determine the right drawdown rate and timing of retirement.  Notwithstanding these benefits, in 2007 (the most recent data year available) the value of income annuity sales totaled just $6.5 billion in a year in which households transferred $300 billion from employer-sponsored retirement plans to IRAs.  In response to that disconnect, the paper cites evidence that “even tiny obstacles such as the need to make a phone call or fill in a form can result in procrastination and lack of action in a retirement savings plan.” It argues that the failure to annuitize results more from the “choice environment” than from underlying preferences. 

“Mental accounting” is a significant behavioral factor influencing the use of income annuities, with investors reluctant to write a big check to purchase a series of small monthly checks.  That problem particularly troubles unsophisticated investors, who see it as a bad deal despite clear mathematic proof otherwise.  The way annuity opportunities are “framed” can also make a huge difference in how consumers choose. In one experiment, an investment offering a $650 guaranteed monthly return induced just 21% of investors to annuitize versus 70% who were offered a “consumption frame” offering “$650 of monthly spending for life.”  These framing issues support my view that income annuities are under-sold largely because advisors are disinclined to sell them since they pay advisors so little compared to other products and result in the advisor losing control of the asset.

Finally, the paper explores policy interventions that have improved savings accumulation behavior and might be profitably brought to bear on during asset decumulation. The key challenge will be to help retirees view income annuities as part of a risk-reduction strategy rather than as a gamble on not living long enough to enjoy the fruits of their labors.