Most Investors Don’t Understand Annuities

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People don’t use annuities nearly as much as economic theory predicts, something called the annuity puzzle. The root of the ‘puzzle’ is familiar enough, economics assume that we all make rational, utility-optimizing decisions about our life, but even an industry as adept at marketing as asset management hasn’t been able to bridge the gap very effectively. A new study suggests that people’s view of annuities are especially irrational simply because the financial instruments are hard to get your head around.

“It is difficult for the average person contemplating retirement to determine how to draw down his wealth,” write Jeffrey Brown, Arie Kapteyn, Erzo Luttmer, and Olivia Mitchell of the Wharton School in their paper Cognitive Constraints on Valuing Annuities. “Choosing a wealth decumulation and consumption strategy that maximizes lifetime utility is a highly complex problem that requires the ability to optimize intertemporally and under multiple sources of uncertainty, aspects that require substantial cognitive effort.”

Annuities: Checking for internal consistency in financial decisions

Instead of weighing in on the annuities problem directly, which would require them to take a position on the optimal amount of annuities people should buy, the researchers set out to see if people were internally consistent in their own valuations, regardless of whether or not those valuations were reasonable.

To do that, they sent participants two waves of questionnaires (more than 2000 completed both) offering different trade-offs between lump sum payments and adjustments to their Social Security benefits, the equivalent of buying or selling an annuity. If someone’s views of annuities are internally consistent then there shouldn’t be a buy/sell spread, which isn’t even close to the actual results. Also, since the surveys were mailed out and participants in the American Life Panel were supplied with internet access if they didn’t have it, participants had the opportunity to research their answers as much as they wanted.

Most people’s buy/sell valuations don’t make sense

First of all, the researchers note that some people’s implied annuity values are basically unjustifiable, either always selling or always buying. Even worse, there is often a large buy/sell spread with the buy and sell valuations negatively correlated to each other. In other words, people who demand high sell prices accept low buy prices, and vice versa.

The buy/sell spreads get wider as ‘cognitive ability,’ measured by level of education, financial literacy, and numeracy, decline, which makes sense. But the study’s sample actually has a higher average level of education than the US population, so even these poor results overstate most people’s ability to understand annuities. Even people that you might expect to have the background to make informed choices about their retirement rely on simple heuristics (eg years to breakeven on an investment) that can lead them to make poor financial choices.

sell buy spread by group 1214 Annuities

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