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Another possible behavioral explanation is the feeling of being poorer after annuitization because of the resulting noticeably lower remaining account balance. This confuses total wealth with the spending power available from that wealth, but it can exert a powerful psychological influence on decisions. Individuals rarely like to see a drop in the value of their financial assets. It is not fun to see $1 million on a financial statement one month and $800,000 the next. Visually, this is what happens with the purchase of an income annuity. The lump-sum paid for the lifetime income protection is removed from the financial portfolio, even though the lifetime income stream is an asset whose present value could be included on the more complete retirement balance sheet. It is not common for individuals to think in these holistic terms.
Curtis Cloke provides a descriptive visual about this behavioral thinking: he calls it the “Scrooge McDuck effect.” Envision Scrooge McDuck diving into his vault of gold coins. He loves to touch and feel his money. This is what we are describing. People like seeing a big number on their financial statements and do not want to see that number reduced—even if they can envision no plausible case where they would need to have full liquidity for all their financial assets.
Perhaps related to this point, surveys have shown that people have a difficult time thinking through the mathematics of translating between lump-sum amounts and lifetime income streams. They may grossly underestimate the value of lifetime income. One million dollars may sound like a lot, but people are much less impressed to hear this might only sustain an annual inflation-adjusted income of around $30,000 to $40,000. As such, individuals may think that $30,000 of lifetime annual income is only worth $300,000, for instance, even though the reality is that this income is worth much more.
Often, retirees may also be thinking about annuities framed in terms of a gamble on the possibility of a long life, rather than as a risk reduction measure aimed at improving that possible long life. Retirees can more easily visualize being run over by a bus after signing the contract than they can being old and without income. They view this as unfair, thinking that the insurance company wins at their expense, instead of the other members of the risk pool. Another helpful technique is to use age-progression software to create a picture of one’s future self, which can help make longevity risk more concrete. In this regard, people may underestimate their life expectancies, calibrating from birth rather than their current age, and not realizing they may live significantly longer than average. Insurance exists to protect us from bad outcomes, but annuities provide insurance against a generally good outcome: living an unexpectedly long time. Emphasizing a break-even age one has to reach for an annuity to provide higher returns misses the point about their insurance value. This mind-set leads to undervaluing lifetime income and a reluctance to annuitize.
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It also turns out that framing annuities as an investment makes them less attractive. A study by Jeffrey Brown, Jeffrey Kling, Sendhil Mullainathan, and Marian Wrobel asked two different groups of randomly selected individuals a question with only a very slight twist in the way the question was worded for each group. They found that 70 percent of respondents would annuitize to obtain $650 of monthly spending for life, compared to only 21 percent who annuitize to obtain a guaranteed monthly return of $650 for life. The same concept with only a slight change in how it was framed led to a very different result.
Another matter is that Social Security already provides an inflation-adjusted annuity which may fulfill basic needs for many retirees. The basic formulation of the annuity puzzle assumes no other outside income sources beyond financial wealth, but Social Security provides such inflation-adjusted lifetime income support. For middle class households, the present value of those Social Security benefits may be larger than the financial portfolio, suggesting that the household already has sufficient reliable income. Individuals have a clear need to set aside a certain amount of financial assets to serve as a contingency fund to cover uncertain and potentially large future medical and long-term care expenses. With Social Security in place, many retirees may not have enough additional financial assets to practically consider an annuity.
Many individuals may also worry about the long-term viability of annuity providers and may view the annuity guarantee as anything but a sure bet. Mistrust of the annuity provider could be related both to (a) whether the provider is taking on too much risk and may be unable to fulfill its promises, or (b) whether incomprehensible fine print exists within the annuity contract that is detrimental to their interests. Fear that a systemic crisis could overwhelm annuity providers and state guarantee associations is common. Such concerns are probably overstated, but they create real fear. Chapter 9 covers this matter in greater depth.
Looking ahead, variable and index annuities with income guarantee riders were designed to overcome some of the behavioral concerns mentioned. They provide liquidity to reduce the finality of the decision, upside potential to keep that hope alive, the ability to keep the contract value of the annuity visible as a financial asset, and the ability to leave a death benefit to the estate. We consider these in upcoming chapters.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon
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