Wednesday, February 13, 2008

Retirement Annuities - Investments or Insurance

Several recent studies have pointed out the economic value and higher adoption rate potential for deferred retirement annuities (“DRA”). These are annuities which could be purchased prior to or at retirement and would commence paying income at a predetermined age later in retirement. Their cost would be a fraction of an immediate annuity and their product characteristics could help overcome some of the behavioral obstacles to annuitization.

Economic and quantitative based research indicate that immediate annuities provide the most “utility” for retirees by helping them smooth the consumption of resources over their lifetime, unconstrained by limited lifetime resources. However, historical annuitization rates have been very low. Unfair actuarial costs, a high liquidity premium and framing are thought to account for this economically irrational behavior.

Unfair actuarial cost - George Akerlof and other researchers propose that adverse selection in the annuity markets contributes to this puzzle. Adverse selection arises due to information asymmetry. Individuals know their level of risk but the insurer does not. This informational advantage motivates “bad risks” to annuitize, thereby driving up costs and prices which in turn repel “good risks”. A Deferred Retirement Annuity, while still subject to adverse selection, could broaden the insured pool using the intuition that the smaller the financial bet needed to annuitize, the more individuals with average mortality would voluntarily annuitize. Greater institutialization of products that include this component could reduce biased actuarial costs.

Liquidity premium - Individuals apparently assign a very high premium to the liquidity inherent in a lifetime savings portfolio. In approaching an annuitization decision, the cost of foregone liquidity is often perceived to be much higher then the risk of poverty should they outlive their retirement savings. One estimate of the cost to give up liquidity and earnings potential for longevity insurance was between .25% and 1.55% per year. Gong & Webb in their 2007 study calculate that: “a household planning to smooth consumption through its retirement would need to allocate only 15 percent of its age 60 wealth to an ALDA with payments commencing at age 85, holding the remainder of its wealth in unannuitized form to finance consumption from age 60 to 85”. A cost shift of this magnitude could make annuitization a relevant choice for many more individuals.

Framing - Brown, Kling, Mullainathan and Wroble focused on the behavioral aspects of this decision in their 2008 study. They suggest that the investment context in which annuitization is often presented could be a source of its rejection. “Survey evidence is consistent with our hypothesis that framing matters: the vast majority of individuals prefer an annuity over alternative products when presented in a consumption frame, whereas the majority of individuals prefer non-annuitized products when presented in an investment frame”.

Annuitization seems to be most often approached in the financial planning process as an alternative investment decision where payback periods and returns depend largely on how long an individual lives. Similar to Social Security in that it has a large insurance component, both are often evaluated based on their investment breakeven payback rather than for their insurance or consumption utility. It seems likely that a partial annuitization would more easily be framed and accepted by individuals as an insurance or consumption decision where the payment is akin to an insurance premium rather than a capital investmnent.

Deferred Retirement Annuities could mitigate a significant and individually unmanageable risk for retirees (longevity). They could also provide the psychological comfort of maintaining a liquid asset pool and reduce the potential risks of inappropriate consumption through a fixed term spending period. The choice to meld an insurance component with an investing component in retirement plans would be superior to 100% of either option for many individuals.

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