Lowell Aronoff is the CEO of CANNEX, one of the largest providers of annuity pricing data to the financial services industry and an expert on the theoretical value of a life annuity. In a recent conversation, I asked him what I ask a lot of annuitization scholars: Does your mother own an annuity?
“I was never able to convince her to buy an annuity, which is very embarrassing,” says Aronoff. “A lot of it had to do with things like ‘What happens if I die tomorrow, what happens if the insurance company disappears, is it a good investment?’ All of which are essentially irrelevant objections but were primary in her mind.”
My mother doesn’t own an annuity either. I’ve traveled to numerous conferences explaining to advisors the value of incorporating annuitization into a retirement income plan in order to hedge the risk that clients will outlive their assets in old age. But most people would rather not lay down a large sum of money in exchange for a pretty modest income. So what’s the problem?
Economists are often annoyed when normal people don’t act in a manner consistent with their models. Annuities provide a perfect example of a product that every economically rational retiree should own and few actual retirees buy. For decades, the infrequent use of annuities in the United States has been considered a puzzle that many economists have gone to great lengths to explain through even more complex models. The likely explanation is that most people aren’t economists.
What’s so great about annuities? To an economist, life is a game with two goals — spend about the same amount each year (because spending a lot this year and a little next year makes us less happy), and spend the highest amount each year. So the best spending plan will be one that is high and smooth. If you want to leave a bequest or prepare for an emergency, buy a product or set money aside for each non-spending goal.
Annuities fit the bill by both smoothing spending and maximizing the amount we can spend each year. Mortality credits provide the spending boost while the guaranteed lifetime income ensures smooth spending. No other financial product provides the same level of expected lifetime happiness in retirement.
One of the most important benefits of an annuity is its protection against running out of money in retirement. Economists see the big drop in spending caused by outliving one’s assets (superannuating) as the equivalent of rolling snake-eyes — you want to do everything you can to avoid it. How do we efficiently protect ourselves against an unexpected significant loss? We buy insurance. Annuities insure against this risk.
If the risk is so significant, why aren’t annuities more popular? Some annuities are very popular. People love their Social Security, which is essentially the mandatory purchase of an inflation-protected annuity. Questions inserted into the Health and Retirement Study in 2008 asked respondents how much they would accept in a lump sum to get them to give up $500 in monthly Social Security payments. The answers revealed two very important insights into how people value annuities.
First, you’d have to pay them a ton of money to get them to give up Social Security income. The average was literally over $250,000, or an amount that would be appropriate if your expected longevity was over 130 years with a zero percent discount rate. Second, nobody has any idea how to value a stream of income. The majority of college-educated respondents weren’t able to come even close to an actuarially fair estimate.
Our unwillingness to sell something for a fair price once we own it is known as the endowment effect. That’s why politicians become ex-politicians when they try to cut Social Security benefits. It’s also why employee unions are so resistant to the mere suggestion that the pensions need to be readjusted. Experiments show that even when a subject is given something that they might not have even wanted (like a coffee mug) they suddenly place a much higher value on the object.
So even though pensions and Social Security are both annuities, people love them. But they don’t love buying annuities. That’s because they have to trade something they have (a lump sum of money) for something that’s a lot more abstract. It shouldn’t be surprising that a 2005 study by Professors Keith Bender and Natalia Jivan found that retirees with annuitized income through defined benefit plans were significantly more satisfied than retirees with non-annuitized retirement assets. The problem is that people aren’t willing to give up their 401(k) stash to get one because of the endowment effect.