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Life Health > Annuities

How to frame annuities more attractively

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As I have noted before, since at least 1965 and the seminal research of Menachem Yaari, economists have recognized that retirees should convert far more of their assets into an income annuity at retirement than they do. Franco Modigliani famously formulated the problem in his Nobel Prize acceptance speech back in 1985: “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 consumers so rarely do what they ought to do in this regard is known as the “annuity puzzle” since the benefits of buying insurance against outliving one’s assets should create strong demand for annuities. However, while consumers want assurance that they won’t outlive their money, they also want to retain control of their money so that they can have flexibility in its use too. Their advisors often want to keep control of the money too.

A recent paper in the Journal of Public Economics by John Beshears of Stanford, James J. Choi of Yale, David Laibson of Harvard, Brigitte C. Madrian, also of Harvard, and Stephen P. Zeldes of Columbia’s Graduate School of Business, “What Makes Annuitization More Appealing?”, takes a new look at the annuity puzzle and offers some suggestions as to what might be done to convince retirees to take greater advantage of these instruments in the future based upon hypothetical survey results from a wide variety of pre-retirees.

Income annuities hedge longevity risk simply and efficiently as risk pooling makes them 25–40% cheaper than do-it-yourself options. Thus retirees who purchase an income annuity assure themselves a higher level of consumption and guarantee it as well. As academics Shlomo Benartzi, Richard Thaler and Alessandro Previtero pointed out in an earlier paper that addressed the issue, “You increase your consumption and eliminate risk at the same time…. Who says there is no thing as a free lunch?”

However, even though the lunch may be free, large numbers of consumers simply aren’t hungry for income annuities. The earlier research from Benartzi and colleagues had argued that the failure to annuitize was more a result of the “choice environment” than from underlying preferences, a conclusion that this newest research suggests is too sanguine.

Despite making annuitization the default option and despite adding much time-consuming paperwork to one’s ability to “opt out” of an annuity—substantial improvements in the choice environment—the newer research reports that 50–75% of defined benefit plan recipients who are able to do so take their benefits in a lump sum. In defined contribution savings plans, only 10% of participants who leave their job after age 65 annuitize their assets.

All or Nothing

One of the bigger obstacles facing retirement plan participants, and one that will be familiar to practitioners in the field, is the “all or nothing” option when it comes to selecting either an annuity or taking funds in one lump sum. Professor Choi, one of the new paper’s authors, explains to Fiduciary News: “If you anticipate lumpy expenditure needs in retirement (e.g., out-of-pocket medical expenses), you want some liquid wealth to cover those expenses. Annuities are not particularly liquid, since you’re constrained by the pre-fixed monthly payout. So you wouldn’t want to annuitize all of your wealth. I think this is one reason why people incline towards ‘nothing’ when they are given an ‘all or nothing’ option.”

On the other hand, the research underlying the paper found that employees are more likely to select an annuity option when a “partial” option is offered. Given the “all or nothing” choice, participants chose the lump sum 50% of the time. With the partial choice, participants picked annuities 80% of the time.

A partial annuitization option makes good practical sense, and is advocated by a variety of practitioners and trade groups, such as the Retirement Income Industry Association. Most people want to hedge their bets. Helpfully, the U.S. Treasury Department has proposed new rules to make it easier for defined benefit plans to offer a combination of an annuity and a lump sum option. Similarly, the research shows that people like annuity products that offer them more flexibility and control, such as a “bonus” payment every year (with a lower regular payment scheme).

Despite such survey responses, consumers don’t seem to be making those sorts of choices in the real world with anything like the frequency suggested by the research. “They have the option to take their lump sum and annuitize part of it in the open market,” says Choi, but they tend not to do so. That failure may be because the search for private annuity options can be so daunting, because private annuities are typically more expensive than those offered by retirement plans, or simply because advisors would prefer not to offer them and lose control of their clients’ money.

The Beshears paper also discusses the impact of framing and how the choice environment can be utilized to increase (or decrease) the likelihood that someone would choose to purchase an annuity for retirement income. Framing changes that increase the appeal of annuities include those that make the option of partial annuitization more prominent. Moreover, frames that downplay the investment attributes of annuities may increase annuitization rates. An annuity is a form of insurance, after all.

One of the more significant findings, though, addresses one of the primary concerns survey respondents cited as a reason not to purchase annuities. According to the authors, “fears of counterparty risk play a large role in their annuitization choices.” They are afraid that the company that provides them with their annuity contract will fail, leaving them high and dry. Choi suggests this is a needless worry because “annuities are already insured up to a certain level, like FDIC insurance, by state funds. It’s just that insurance companies can’t advertise this fact.”

While that statement isn’t quite accurate—the FDIC is backed by the federal government while state guaranty funds are backed by other insurance companies, making them less analogous than Choi suggests—it is true that annuity utilization is undercut by the inability of insurance companies and their agents to advertise, accurately, the existence of the guaranty funds in the sorts of ways that banks advertise FDIC insurance.

Promising Approach

The researchers caution that we should not make too much of these new results since they are hypothetical and will need to be field tested with real consumers making real choices. “It would be nice to study instances where employers change a feature of the way they offer annuities in their plans, and see how employee choices change subsequently,” admits Choi.

The view of the income annuity as anything like a routine first-choice retirement income option remains a good ways off. Too many individual factors can get in the way of using guaranteed income annuities despite their obvious benefits. However, the new research is clear that if and when partial annuitization strategies are regularly offered and recommended, especially when they are well framed, the idea that income annuity usage would be “extremely rare,” as Modigliani observed nearly three decades ago, will no longer be remotely accurate. And that would be a very good thing indeed.


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