Why are you so scared of annuities?

The economic mysteries of daily life.
March 1 2008 7:17 AM

Money That Lasts Forever

Why are we so scared of annuities?

Senior citizen
Are annuities a good choice for retirees?

Here's what I like about insurance: You pay the insurers money when you do not desperately need it, and then the insurers pay you money just when you need it most.

Curiously, this is not what other people seem to like about insurance. Most people do not try to arrange for insurance payments to arrive when they will need them most. Instead, they arrange for insurance payments to arrive after bad luck.

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If your house has just burned down, "when you need money most" amounts to the same thing as "after bad luck." But what if your son has just been accepted by Harvard? That is when the money would be useful, but we are temperamentally more inclined to insure against the tragic death of a child. It goes against the grain to insure against "good news."

Meanwhile, we pay through the nose to insure a cell phone—the loss of which is bad luck but hardly a life event that suddenly makes money more valuable.

In contrast, we do not buy insurance against living until the age of 95—a "good luck" event that goes hand in hand with a huge need for extra money. Insurance against longevity is easy to obtain: It's called a "life annuity"—sometimes just an "annuity"—an investment product that pays you an income as long as you live. If you die young, you lose money on the deal, but who cares?

Yet we seem to dislike annuities. They barely exist in the United  States. In the United Kingdom, they are compulsory for those who want tax relief on their pension savings. Still, we buy them kicking and screaming.

Quite why we have such an aversion to annuities is not clear. True, money spent on an annuity is not available as a lump sum on a rainy day. Annuities are also expensive: After all, insurers must fear that only vegan teetotalers will buy them. But the truth is that our reluctance even to dabble in annuities is almost certainly irrational. So, what quirk of human nature is standing in our way, and what might insurers (and governments) do to nudge us in a more sensible direction?

One indication comes from new research by four economists, Jeffrey Brown, Jeffrey Kling, Sendhil Mullainathan, and Marian Wrobel (PDF). Using an Internet-based survey, they presented respondents with a series of comparisons between pairs of fictitious retirees who had made different decisions about funding their retirement. The survey asked who had made the better choice. Brown and his colleagues found that whether their respondents favored those with the annuities depended entirely on how the question was presented. Annuity purchases look attractive when described as sources of spending. For instance, when told that "Mr. Red can spend $650 each month for as long as he lives in addition to social security. When he dies, there will be no more payments," respondents preferred Mr. Red's choice (implicitly, an annuity) to Mr. Gray's savings account, which was flexible but would run out of money at age 85 if he spent $650 a month.

But when described as investments, annuities suddenly became unpopular. Few fancied Mr. Red's decision when told that he had invested "$100,000 in an account which earns $650 each month for as long as he lives. He can only withdraw the earnings he receives, not the invested money. When he dies, the earnings will stop and his investment will be worth nothing."

The two Mr. Reds, of course, chose exactly the same product described in a slightly different way. The lesson: Don't focus on what rate of return an annuity produces. Just think about what you can spend if you buy one.

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