The Psychology of Why People (Used to) Hate Annuities, Part 2

The following is an excerpt from Snap Judgment: When to Trust Your Instincts, When to Ignore Them, and How to Avoid Making Big Mistakes with Your Money by David E. Adler. This is a fascinating book about the psychology of money and how our instincts and emotions often harm us when we make investing decisions. The excerpt below is part two of a two-part series (part one was posted earlier today.)

Annuities

There are rational reasons to buy an annuity when you retire. The foremost is you don't have to worry about outliving your money. With a guaranteed check coming in each month, you need never live your final years in poverty. On top of this, annuities also have the potential for higher returns than from traditional investments because of their inbuilt insurance features—if you survive that is. For people who make it into their 90s, the income from an investment in traditional assets would only be 40% compared to the income from the same amount of money spent on an annuity. The fact that people aren't necessarily good at handling their money once they have retired makes the arguments in favor of annuities even more compelling. This is why the wildly enthusiastic consensus among most economists, to say nothing of the insurance industry, is that annuities are a great thing.

But the consensus among the public is that annuities aren't so hot: Only a tiny fraction of people buy them. Many people hate annuities, which puzzles academics. Hence, economist Franco Modigliani, in his Nobel Prize acceptance speech, said, "It is a well-known fact that (individual) annuity contracts...are extremely rare. Why this should be so is a subject of considerable current interest. It is still ill understood."

It is no longer so "ill understood." The answer has to do with human psychology. Annuities, until recently, were a bad match for what most people, as opposed to most economists, worried about. One rational reason not to buy annuities is they tend to be very expensive, with the pricing opaque and hard to figure out. Also, they make the most sense if you plan to live a long time, and therefore attract people who are unusually good at doing this. Insurance companies have noticed, and priced annuities accordingly, meaning they are costly. They aren't actuarially fair, and the pricing favors the long lived instead of the general population. And they have some risks: Because they are contracts with individual corporations, if the insurer goes bust, there goes your annuity. Finally, annuities are complex and hard to understand, and people don't like complexity. The complexity starts with the name, with many things called an "annuity" that aren't annuitized. For instance, insurance companies offer products with annuity in their name that really resemble mutual funds: You don't have to surrender your principal and they don't guarantee lifetime income. The annuities I am referring to are "life annuities"—irrevocable insurance products that in exchange for a payment offer a minimum level of guaranteed income that lasts a lifetime.

The central problem is framing: Consumers view annuities as risky gambles rather than insurance. If we die early, we lose; if we live a long time, we win. Economists, and insurance companies, view annuities as insurance: not against dying but against the risk of outliving your wealth. They call this longevity risk—the risk that you live longer than you expected and have budgeted for. Anyone else would consider living to a ripe old age a good thing. Not economists who fret about all the financial dangers involved, which can be mostly taken care of by annuities.

This brings us back to Jeffrey Brown's framing experiment. Says Brown, "If I think about how much money I have in a bank, then an annuity looks horrible. I am giving up a lump of wealth and whether I get it back or not depends on how long I live; so it seems risky. But if I think about how much I am going to be able to spend every day, then an annuity looks great."

Insurance companies are well aware of our psychological problems with annuities, and current behavioral economics research into this area. Their psychological insights are allowing them to engineer products that meet consumer's psychological as well as financial needs. This includes "reframing" our perception of annuities by highlighting their insurance features. Some annuities are now explicitly offered as longevity "insurance"—these are usually ones designed to kick in very late in life, at 85 plus. Or another idea is to link an annuity to long-term care insurance, a sort of two-for-one product, addressing two big concerns of the elderly: cash flow and healthcare. Variable annuities try to emphasize growth and income, appealing to our desire for both. The biggest changes are in "guaranteed death benefits." Insurance companies are trying to take the "gambling with your life" feature out of annuities, through guaranteed death benefits. The idea is you, or rather your estate and beneficiaries, get the money back if you die before the annuity has kicked in. In fact, the development of annuity products is so rapid and extensive, much of it based on applications of behavioral economics, that insurance companies, once seen as plodding and dull, are at the center of financial innovation. It looks like they will succeed in making annuities popular.

But I still see challenges ahead because there is one remaining big psychological—and real—problem with annuities, and that is control. If you buy an annuity, you give up control of your money. Maybe the insurer will let you buy the annuity back, but such a rider is extremely expensive. And a true annuity is irrevocable. "Irrevocable" is not an easy concept or word to swallow. Once you buy an annuity, the money is no longer yours. Before you had, say $1,000,000. After the purchase, it now is the insurance company's. You get a check every month, but you no longer have the $1,000,000 to play with.

Even though an annuity reduces the risk you won't outlive your money, there are other risks to worry about, like the risk you won't have enough money exactly when you need it, if you get really sick, for instance, or have a sick grandchild. It doesn't have to be so morbid: You might prefer the flexibility of playing with your money. For all I know, you might have the desire to buy a $15,000 bottle of champagne and spray it around a nightclub, or go on a mega shopping trip to Dubai and end up broke afterward. These might be your desires. But it would be hard to live your dream on your carefully doled out "oldster" allowance in the form of an annuity from your insurance company.

So the question comes down to this: Do you want all your consumption needs insured in the form of annuity, or just some or maybe none of them? I don't think this is about being rational versus irrational; it's just a matter of your tastes, how you want to invest your money, and how you want to spend it.

Comments

[Roy Nelson]

I would only consider Annuities for short term income (maybe five years at a time) just because of possible/likely high inflation down the road.

[Mike Hunt]

The key question I think is about control. There are so many unknowns in the course of the remainder of your life (like inflation, interest rates, etc) that dumping all you have into an annuity seems risky. Maybe 30% of your savings can go into this vehicle but the all or nothing shot seems like a bad deal.

-Mike

[BobL]

I'm disappointed that these postings were made on FMF. Annuities are for salesmen to have something to confuse the math challenged general public. Far too many Wall street and main street wizards making their high-brow living off of fees provided by these type of "investments". Help people save money and take a slice of that instead of confusing them and skimming from the sell. And no, I don't mean sell them high cost mutual funds or recommend hot stock picks instead.

[Debbie m]

I don't have these psychological problems; I think annuities sound fabulous. The problem is that spending 4% myself would actually be more than what I could earn from an annuity with the same money. I'd always thought that they could give me more money per month based on average life span whereas I'd have to withdraw my own investments based on an above average life span (just in case), but the research I did showed just the opposite.

Maybe things have changed since I last checked them, but that's why I hate annuities. Too much goes to profits and not enough to the people buying the annuities.