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Jeff Brown Tackles Tough Annuity Questions

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In the 15 years since Jeffrey Brown completed his Ph.D. in economics at MIT, he’s been among the most prolific and influential researchers in the field of retirement policy.

In order to establish Jeff Brown’s importance as a scholar, one need only list his many research awards and publications in top-ranked journals, or perhaps his appointment by President Bush to the Social Security Advisory Board and service as senior economist at the White House Council of Economic Advisers.

In his spare time, Brown, who is a finance professor at the College of Business at Illinois, also managed to co-found the influential Journal of Pension Economics and Finance, serve as the associate director of the Retirement Research Center at the National Bureau of Economic Research and be a fellow at the TIAA-CREF institute. And this month, the Retirement Income Industry Association, together with media partner Research magazine, presents Brown with its award for achievement in applied retirement research.

In other words, Brown has accomplished quite a bit in the last decade and a half. There’s a good reason for that. First, he’s a very smart and hardworking researcher. Second, he’s a great guy to work with. Wharton professor Olivia Mitchell calls him a “delightful co-author and wonderful teacher and mentor.” The list of economists who’ve worked with Brown is a who’s who of this generation’s most influential scholars.

Third, and probably most importantly, he’s a policy wonk. He just can’t get enough of studying economic policy, and he knows as well as anybody how important it is that we get retirement policy right in the United States.

Tackling Annuities

Brown’s most famous and widely cited work is on annuities. Annuities have the ability to capture the imagination of the young academic with an interest in economic policy. Many of us see economics as a type of religion—one that we believe in based on a faith in human rationality because economic theory does an excellent job of explaining how the world works using a toolkit refined over decades by scientists. Unfortunately, our economic tools can’t explain why so few Americans buy annuities.

Finding out why people don’t buy annuities is a tempting subject for a policy addict. And the new defined contribution era adds to the urgency of understanding why so many retirees don’t buy annuities. The baby boom generation is the largest American cohort in history, and they will be the first to fund retirement through a defined contribution savings system. How this generation chooses to spend down these assets will have a big impact on their own welfare and on the younger generations who will need to support them in old age.

One of the most important differences between pensions and sheltered retirement accounts is that pensions don’t make workers decide whether to annuitize. Pensions simply take retirement savings, invest them and convert the investments into a lifetime income. Most workers who have a pension really like the idea of lifetime income payments and don’t seem to care much that the pension won’t write a consolation check to their heirs if they die early in retirement. Many of these same workers wouldn’t even consider buying an annuity with their 401(k).

If you value your own welfare in retirement more than you value giving money to your kids, you’ll want to turn retirement savings into something that looks like a pension. Traditional economic theory says that most workers should buy life annuities. They provide a higher level of spending each year and a retiree will never run out of money. Brown’s earliest work tried to figure out why so many American’s didn’t actually buy any of the annuities economic theory says they should want.

Brown’s first academic article (published in the prestigious American Economic Review—not a bad first publication) looked at whether people don’t buy annuities because they’re too expensive. One of the good things about pensions is that they are like a group annuity policy—all of the workers, even the overweight smokers, are part of the annuity pool. Private annuities create an adverse selection problem where those who expect to live the longest will be most interested in buying a product that pays an income for a lifetime.

Brown and his co-authors found that adverse selection does make annuities more expensive to the average worker by about 10–15%. But even after accounting for the annuity already provided by Social Security and the threat of inflation, retirees would still optimally annuitize a significant portion of their savings at retirement. The mystery of under-annuitization remained.

Much of Brown’s subsequent research continued to explore possible reasons why so few Americans buy an annuity. Does the system of taxing annuities impact ownership? In a 1999 article in National Tax Journal, he found that the system of taxing annuity payments doesn’t provide enough of a disincentive to explain low rates of annuitization (although that didn’t stop him from proposing a more efficient method of taxation in the article). Is it because married couples have a lower incentive to annuitize? In another article, Brown found that they do, but they’d still be better off buying an annuity.

After exploring theoretical reasons why someone might rationally choose not to buy an annuity according to economic theory, Brown decided to look more closely at retirees to see whether economic models could predict which ones actually bought an annuity. After estimating how much value each household should place on annuitization (for example married couples will place slightly less value on an annuity), it turns out that economic factors that should make people want them more do in fact increase demand for annuities. One exception is that those who feel more strongly about giving a bequest aren’t actually less likely to annuitize.

Weighing Risks

Annuities provide a smooth income in retirement, but sometimes a retiree’s expenses aren’t so smooth. One reason annuities are so rare in the U.S. may be the significant spending risks we face—particularly the risk of high health care costs. Spending money on an annuity can put these assets out of reach. In his second article published in American Economic Review (AER), Brown and his co-authors find that the optimal strategy is to simply buy insurance to protect against health risks including long-term care costs and then annuitize the rest. If the ability to buy market insurance is limited, annuities can still be superior to holding money in an investment account if the health risk occurs later in life when 401(k) wealth might be depleted.

Brown concludes in his second AER article that there must be some behavioral explanation for the low level of annuitization since he’s running out of rational economic reasons why people don’t buy them. In his third AER paper, he explores the possibility that retirees who have been so focused on viewing their 401(k) accounts as an investment will have a hard time now viewing them as an income stream.

In an experiment, Brown and his co-authors ask people how much of their retirement assets they’d invest in an annuity (they don’t call it an annuity; they just describe what the product does). It turns out that people really want annuities when the product is presented in an income frame as providing $650 a month for the rest of your life. But when it was presented as an investment that provides a regular monthly return but stops making payments when you die, people didn’t like the product. This is consistent with a later study that shows that many people place a really high value on the annuity income they get from Social Security—in many cases higher than the amount they’d be willing to pay for a private annuity.

A possible policy solution to increase rates of annuitization is to nudge retirees toward buying annuities. One example might be to make partial annuitization of 401(k) assets a default option at retirement or at a certain age. This would result in much higher rates of annuitization among retirees, but some have complained that pushing lower-income households to buy more annuities may be harmful if they don’t live as long as other retirees. Brown finds that while wealthier annuitants do live longer, lower-income retirees would still benefit significantly from annuitizing and would certainly be better off than if they hadn’t annuitized at all.

In recent research conducted with MIT professor Amy Finkelstein, Brown looks more closely at why people also don’t buy long-term care insurance. A rational retiree should buy a life annuity and an insurance policy that pools the risk of unanticipated health expenses. Retirees aren’t buying enough annuities, and they’re also not buying as many long-term care policies as they should. The authors estimate the significant value of long-term care insurance (especially for women) and even point out a few problems in the industry. In a subsequent paper, Brown finds that many don’t buy long-term care insurance because they underestimate their need for coverage, and will rely on savings or the help of others, and also because they either don’t trust insurance companies or believe that coverage is too expensive.

Jeff Brown continues to study ways to improve the defined contribution retirement system in the U.S. He’s one of the few academics who remain productive out of a sense of curiosity and a commitment to creating better economic policy backed up by theory and evidence. Moreover, he has served as a mentor to many other scholars in the field of retirement economics. His influence on that field will be felt for a long time to come.

— More by Michael Finke on ThinkAdvisor: