Expert explains why people don’t buy annuities

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.