How to frame annuities more attractively

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.