In Cuffelinks 32, I explained that life annuities have merit for people who seek to smooth their consumption over a lifetime of unknown length. And yet we find little annuitisation in Australia or around the world, and so we have an ‘annuity puzzle’. In Cuffelinks 34, I explained some of the rational challenges to annuities, but well-respected academics such as Jeffrey Brown find it difficult to accept that the lack of annuitisation can be explained solely by rational reasons. In this article I outline a number of behavioural reasons why people may not purchase life annuities.
This article heavily references Jeffrey Brown’s work in his paper Rational and Behavioural Perspectives on the Role of Annuities in Retirement Planning but much of this stems from broader behavioural finance research by the likes of, among many others, Richard Thaler and Shlomo Bernartzi, and ultimately, Nobel Prize winner Daniel Kahneman.
Complexity and financial literacy. There are many research papers which demonstrate the lack of financial literacy across the population. Lifecycle modelling is highly complex and most people would not be capable of making an accurate assessment of retirement needs, even if they have reasonable levels of financial literacy (though of course they may seek advice). Uncomfortable that a decision is beyond their understanding, an individual may be anchored to the status quo (inertia), namely the default option. This has greater resonance when the active decision to purchase an annuity is one which is not always reversible, though some life annuity contracts now allow an exit within a fixed time period. For super fund money the default option is typically an allocated pension product but one can quite easily redeem and take a lump sum. A life annuity is nowhere in sight when it comes to default retirement solutions.
The power of defaults cannot be underestimated. Defaults, depending how they are framed, can potentially be interpreted as a recommendation by the company. And defaults often persist for individuals because to move away requires an active decision. An example is the Swiss pension system where an annuity is commonly the default at retirement (with an ability to take a partial and sometimes full cash lump sum), and annuitisation rates are extremely high.
Mental accounting and loss aversion. In US focus group research, people viewed the purchase of a life annuity as ‘gambling on their lives’. This doesn’t fit with the rational reasons for purchasing life annuities, namely the guarantee of an outcome and the removal of the risk of unknown lifetimes. In effect, Brown suggests that the mindset of consumers with respect to annuities is behaviourally influenced rather than completely rational.
Brown suggests that an individual may view insurance differently to an economist. Where an economist views an insurance contract as a way to manage a risk, an individual may frame an insurance contract as a payment to counter a bad event. Yet many people may not view living a long time as bad, so they would not view annuities as attractive. Surely education and advertising can be used to persuade people that living a long time without sufficient means is bad.
Regret aversion. Consider the scenario where someone purchases a life annuity and then discovers they are terminally ill. Not only are they distressed about their life coming to an end but they will also have great regrets that they purchased a life annuity. The fear of experiencing this regret may be a deterrent to annuitise.
Loss of control. This can be considered in a rational framework (annuitisation leads to a loss of liquidity as one exchanges wealth for an income stream) but also from a behavioural perspective. Brown refers to psychology literature on the ‘illusion of control’ where greater control over the financial future is gained from accessible wealth. My feeling would be that the rational reason (loss of flexibility, counterparty exposure etc) is a stronger reason which can be explored further.
Framing. Framing refers to how information is communicated to us, and how it affects the decisions we make. A simple example could be a treatment for serious illness, where one description may be “taking this treatment will give you a 30% chance you will live”, while another is “taking this treatment will leave you with a 70% chance of death”. The way annuities are framed may affect their level of acceptance by investors. Unfortunately, annuity providers are likely to encounter entrenched views of annuities as negative and it will take time to counter such broadly-held prejudices.
And so the annuity puzzle remains unsolved – there remains no seminal piece of research which reconciles why a product which has theoretical appeal does not gather significant market acceptance. Further work is needed on both rational and behavioural reasons, as well as the interaction between the two. While behavioural research always sounds exciting, in my experience it is easier to display the direction of an effect more than quantify its impact.
In the meantime addressing obvious rational impediments (eg. irreversibility, money’s worth transparency, supply side impediments, barriers to product innovation, and the issue of counterparty risk) as well as continued focus on the way the product is framed to individuals (managing the risk of living a long time poor) can only improve the small signs of growth in life annuity sales in the Australian market.
David Bell’s independent advisory business is St Davids Rd Advisory. David is working towards a PhD at University of NSW.