New Research Suggests Why It’s Hard to Sell Annuities to ERISA Plan Participants
One of the nagging riddles of Modern Portfolio Theory is the so-called “Equity Premium Puzzle.” Of course, with the ascendancy of behavioral finance, we have a better understanding of the irrationality of investors. Modern Portfolio Theory relies on the assumption of the rationality of markets. Perhaps the Equity Premium Puzzle isn’t a puzzle at all. Perhaps it’s a victim of false assumptions.
But there’s another conundrum faced by academic researchers. It’s called the “Annuity Puzzle.” Mathematically, it makes more sense to annuitize than to take a risk with a lump sum payment. A forthcoming article titled “What Makes Annuitization More Appealing?” (Beshears, John, James J. Choi, David Laibson, Brigitte C. Madrian, and Stephen P. Zeldes, 2013, Journal of Public Economics, forthcoming.) The paper describes the results of research that both explains why ERISA plan participants fail to take advantage of annuities and suggests what might be done to convince those participants to “do the right thing.”
According to the paper, one of the biggest obstacles facing retirement plan participants is the “all or nothing” option when it comes to selecting either an annuity or taking their funds in one lump sum. It cites statistics like this: “only 10% of participants who leave their job after age 65 annuitize their assets” and “between 50% and 75% of eligible DB benefits are taken as a lump sum, even though the annuity is the default option and opting out requires time-consuming paperwork.”
Why do most employees reject annuities when given the option of “all or nothing”? James Choi, Associate Professor of Finance at Yale University and one of the authors of the papers, explains “If you anticipate lumpy expenditure needs in retirement (e.g., out-of-pocket medical expenses), you want some liquid wealth to cover those expenses. Annuities are not particularly liquid, since you’re constrained by the pre-fixed monthly payout. So you wouldn’t want to annuitize all of your wealth. I think this is one reason why people incline towards ‘nothing’ when they are given an ‘all or nothing’ option.”
The researchers conducted two large surveys of people between the ages 50 and 75. One of their more significant findings concluded employees are more likely to select an annuity option when a “partial” option is offered instead of an “all or nothing” option. Given the “all or nothing” choice, participants chose the lump sum 50% of the time. With the “partial choice,” participants picked annuities 80% of the time. Of course, given the partial choice, participants will only choose full annuitization 21% of the time (as opposed to 50% of the time when given the “all or nothing” option).
Despite these responses, we do not see retirement investors in the real world taking advantage of partial annuitization when they are free to do so. “They have the option to take their lump sum and annuitize part of it in the open market,” says Choi, but then it turns out that they usually don’t ever end up taking that second step. Once you are looking for an annuity in the open market, the search costs become daunting. And you are likely to get a worse deal on an annuity because annuity providers have to charge enough to cover their distribution costs, and these are likely to be higher in the open market than within the employer plan.”
The paper goes on to discuss the impact of framing, inflation and payout options and how those can be structured to increase (or decrease) the likelihood someone would choose to purchase an annuity.
One of the most significant findings, though, addresses one of the primary concerns survey respondents cited as a reason not to purchase annuities. According to the authors, “fears of counterparty risk play a large role in their annuitization choices.” In other words, participants worry that, if the insurance company they purchase the annuity from fails, they will lose their entire principal. Choi says this is a needless worry because “annuities are already insured up to a certain level, like FDIC insurance, by state funds. It’s just that insurance companies can’t advertise this fact.”
Could the attraction to the partial option be tied to the need for guaranteeing principal safety? It could be investors aren’t will to bet the house on the financial stability of the annuity provider, but there is a partial threshold at which they would be willing to bet a portion of the house. Choi says, “Certainly it’s perfectly reasonable to feel better about betting only part of one’s wealth on a risky gamble than betting all of one’s wealth.”
The researchers caution not to take too much from the results… yet. They warned against assuming too much as the research focused on “hypothetical” questions. The authors said further field studies would be the logical next step. “It would be nice to study instances where employers change a feature of the way they offer annuities in their plans, and see how employee choices change subsequently,” says Choi.
Still, the view of the annuity as a panacea remains a long way off. Too many individual factors can impede one’s desire for an annuity. Will an annuity ever become a universal choice? “Not if you have lumpy expenditure needs,” says Choi. “In particular, if you have a big medical expense, then you need a lot of cash now. But if you’ve just gotten very sick, the value of your annuity has fallen a lot because your life expectancy has fallen a lot. So even if you could borrow against your future annuity payments, that’s not so helpful for dealing with medical expense shocks.”
Like the omnipresent Equity Premium Puzzle, the Annuity Puzzle appears destined to stay with us. “I think the annuity puzzle and the equity premium puzzle are two very different things,” says Choi. “But it’s true that in both cases, there’s clearly something wrong with the assumptions underlying our theories.”
And that’s why we expect further research to enlighten us even more.
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