Finding out why people don’t buy annuities is a tempting subject for a policy addict like Jeffrey Brown, a finance professor at the College of Business at Illinois. 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.
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 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