July 5, 2012
Public Perplexed About Annuities
Sales of annuities are slow, because most retirees simply don’t know how to assess their value, new research concludes.
Many of the nation’s top retirement experts agree that annuities are the best solution for retirees struggling with the best way to invest and spend a lifetime of savings.
Annuities have a singular benefit: they guarantee monthly income, no matter how long the retiree lives – something a savings account can’t always do. This constant, pre-determined stream of income has the added advantage of preventing financial mistakes as the elderly lose cognitive capacity, according to Harvard economist David Laibson. Smart Money magazine has dubbed annuities “dementia insurance.”
Yet sales of fixed and variable annuities have been largely flat over the past decade. This “annuity puzzle” has befuddled the academy for years.
Research by the Financial Literacy Center, a joint effort by George Washington University, the Wharton School, and the Rand Corporation, concluded that most people avoid annuities – they “stick to the status quo” – because they don’t understand how they work.
“How can they make these decisions if they don’t understand what a good decision is?” said a Rand senior economist and one of the paper’s co-authors, Arie Kapteyn. “We have to do something about the fact that people have to make these decisions” about managing their retirement wealth.
Social Security benefits are the most common annuity, so one would think they would be easiest for most people to understand. To test this, the Financial Literacy Center asked research participants two questions about their Social Security benefits: a) How much are you willing to pay in cash to get an additional $100 per month in monthly benefits for the rest of your life and b) How much cash would we have to pay you to give up $100 per month in benefits?
Kapteyn said that if the research subjects understood how annuities worked, their answers should’ve been roughly equal. Instead, individual respondents’ estimates of the annuity’s value to them varied wildly and inexplicably, from $17,500 to $200,000.
Further, those who were willing to pay next to nothing for an increase in their monthly benefits asked for enormous sums of money to compensate for a $100 decline in their monthly benefits. There was even a negative correlation: the more money people needed in order to give up $100 per month, the less they were willing to pay for receiving the extra $100.
There’s other evidence of confusion out there. Time after time, people in experiments and in the real world choose cash – a “lump sum” pension – over annuities. One research paper examined the behavior of retiring Oregon public employees. They had a choice between taking an annuity for their entire pension or taking a partial monthly annuity and a partial lump sum. They tended to choose the partial lump sums, even though the present dollar value of the annuity they gave up was higher.
Retirees also avoid annuities, even though figuring out how much retirement savings to spend every year is more complex.
Paradoxically, some employees choose annuities over cash. The vast majority of IBM employees picked the annuity when given the option of taking their pensions as an annuity, lump sum, or combination of the two.
Lump sums, annuities, spending down retirement savings – Squared Away invites readers to explain how they make this critical decision.
To read a classic research paper showing that annuities may be the best route for many retirees, click here.
Full disclosure: Some research papers cited in this post were funded by grants from the U.S. Social Security Administration (SSA) through the Retirement Research Consortium, which also funds this blog. The opinions and conclusions expressed are solely those of the blog’s author and do not represent the opinions or policy of SSA or any agency of the federal government.