Financial industry professionals have long grappled with the so-called “annuity puzzle” – the quandary as to why savers who would seem to rationally benefit from annuitizing a portion of their savings do not avail themselves of the opportunity.
Now, in a new paper slated for publication next month in the Journal of Economic Perspectives, three leading academics offer ideas on why annuities are less popular than economists might expect them to be and what might be done about this state of affairs. A preview of their working paper can be found on the Allianz Global Investors Center for Behavioral Finance’s website, whose director Shlomo Benartzi (left) co-wrote the treatise with Richard Thaler and Alessandro Previtero.
The authors define the problem using Franco Modigliani’s original formulation given in his 1985 Nobel acceptance speech: “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.” Little has changed in a quarter century in that the products remain unpopular yet would tend to solve complex problems that retirees struggle with.
One of those “problems” is increasing life expectancy, yet as longevity increases to unknown horizons, Americans are actually retiring earlier and saving less, trends that are hard to reconcile even aside from the reluctance to annuitize.
Indeed, the authors cite the pioneering research of Menachem Yaari whose seminal 1965 research on the economics of annuities showed that a rational actor (with no legacy goals for inheritors) should convert all his assets to an annuity at retirement. That is because policyholders who die early are subsidizing those blessed with a long life, making the annuity essentially an insurance policy with a negative premium.
Benartzi, Thaler (left) and Previtero cite research showing individuals with non-negligible financial assets gain substantially from annuitization, and they also cite research tending to refute supposed explanations for consumer reluctance to purchase them–including fees, prices or inflation concerns.
What’s more, they show that the lack of annuities (by which the authors mean fixed immediate annuities, not variable annuities) adds layers of complexity to people’s financial lives. “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,” they write, and indeed they go on to show retirees tend to underspend in retirement, a problem that annuitization could ease.