The Psychology of Why People (Used to) Hate Annuities, Part 1

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 one of a two-part series. The second part will run later today.

Take the following retirement quiz about two people who have made permanent decisions on how to spend a portion of their money in retirement. Which sounds like a better deal to you?

Quiz #1

Each person has some savings and can spend $1,000 each month from Social Security in addition to the portion of income mentioned in each question. They have already set aside money to leave for their children when they die. The choices are intended to be financially equivalent and based on personal preferences for spending in retirement.

Mr. Red: 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.

Mr. Gray: Mr. Gray can choose an amount to spend each month in addition to Social Security. How long his money lasts depends on how much he spends. If he spends only $400 per month, he has money for as long as he lives. When he dies, he may leave the remainder to charity. If he spends $650 per month, he has money only until age 85. He can spend down faster or slower than each of these options.

Results: How did you answer? It is likely that you felt Mr. Red had a better deal than Mr. Gray. His consumption was guaranteed for life whereas Mr. Gray risked running out of money after age 85.

This financial quiz (actually a psychological experiment) was developed by the economists Jeffrey Brown, Jeffrey Kling, Sendhil Mullainathan, and Marian V. Wrobel, who wanted to understand what factors went into people's retirement decisions. They found the majority of participants when presented with this exact choice preferred Mr. Red's situation to Mr. Gray's.

Then the economists varied the experiment slightly. They rewrote the setup paragraph using new language and new descriptions, which conveyed a slightly different message. They tested it on a new group of participants.

Here is their new quiz. Try taking it. You might not change your answer because you have already seen the original version. Nonetheless, try reading the introductory paragraphs slowly and carefully, letting it put you in a new frame of mind before making your decision.

Quiz #2

Two people have made permanent decisions on how to spend a portion of their money in retirement. Which sounds like a better deal to you?

Each person has some savings and receives $1,000 each month in social security, in addition to the portion of savings mentioned in each question. Each person has chosen a different way to invest this portion ($100,000) of their savings. They have already set aside money to leave for their children when they die. The choices are intended to be financially equivalent and based on personal preferences for investing in retirement.

Mr. Red: Mr. Red invests $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.

Mr. Gray: Mr. Gray invests $100,000 in an account which earns a 4% interest rate. He can withdraw some or all of the invested money at any time. When he dies, he may leave any remaining money to charity.

Results: The majority of people who took this quiz said Mr. Gray had a better deal.

Quiz #1 and Quiz #2 are, of course, exactly the same in financial terms. But in psychological terms they couldn't be more different, because of the differences in language and descriptions. In the first quiz, everything is presented in terms of consumption: Mr. Red and Mr. Gray spend the money. When taking the quiz, you are confronted with the consumption consequences of financial decision. The second quiz emphasizes investments. It uses words such as invest and earnings. It mentions the account balance. When taking this quiz, you think about the return on the investment.

Psychologically, these differences in perspectives are known as frames. The underlying information is the same, but we filter it and make our decisions depending on how the choices are couched. When the financial decision is framed as a consumption decision, Mr. Red's guaranteed spending money looks the good deal. When the financial decision is framed as an investment decision, Mr. Gray's opportunity to invest his money looks like a better deal. In another words, context can be as important as content when it comes to financial decisions, even very important financial decisions.

I spoke to Mr. Brown (this is beginning to sound like a Quentin Tarantino gangster movie where each character is named after a different color, but here I am referring to the eminent economist Jeffrey Brown of the University of Illinois who cocreated this experiment). He said this of his results: "Traditionally, economists have had the underlying view that people are hyper-rational and are trying to maximize their happiness (what economists call utility). If you believe that, then how you package the information shouldn't impact their decisions. But you have huge swings in how people behave depending on how the information is packaged."

The larger point of the experiment is not just that framing has an impact; it is specifically about how retirement planning is "framed" in the U.S. and how we are conditioned to think about it. Should our financial focus be on building wealth for retirement, or on what we can consume after we retire? Is the right measure of financial success how much wealth we have when we retire? Or how much we can spend each month after we retire? Like the quiz, these are different ways of looking at essentially the same problem.

It is Jeffrey Brown's contention that we have been conditioned to think about retirement as mostly an investment decision, similar to quiz #2. Whereas he feels thinking about retirement as largely a consumption decision, similar to quiz #1, is more appropriate. Says Brown, "The messages that individuals receive when encouraged to save are all about how much you have in your account and your rates of return. But really you should think about how much can you eat each month, how much can you consume." This subtle conditioning or "framing" has a real result when we retire. Most people see themselves as Mr. Gray and choose the investment solution. However, most economists feel we should be in a consumption frame of mind, and follow Mr. Red's choice.

If it is not already clear, Mr. Red has bought an annuity: $650 a month. The experiment is an attempt to explain why annuities are so unpopular, despite their many economic advantages.

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Part two of this piece will post at 7:15 pm today Eastern time. Update: Here's part 2.

Comments

[Dan Holt: Laid Off]

Great article. An annuity is a very helpful tool, and those who don't like the payments stop when you die part, you can by annuities that have minimum payouts. For instance, Mr. Red could by a single-life 20cc annuity that will continue to make payments for 20 years, regardless of whether Mr. Red is alive. If Mr. Red lives another 30 years, the annuity will still keep paying out. Downside: in TX for 65 year old male, the $100,000 monthly annuity payment would drop from $684 to $596 to pay for the 20 year guarantee. Annuities get a bad rap, when variable annuities are the only real villains. The immediate annuity Mr. Red purchased is a great investment, in effect buying a pension.

[LotharBot]

Part of the "trick" to quiz #2 is the way the earnings are stated: Red earns $650/month while Gray earns 4%. This frames the issue as though Red has an income while Gray is investing. You don't actually "think about the return" in each investment in terms that can be easily compared.

To state things equally, Red is earning 7.8% yearly but loses his principle when he dies and can't compound interest, while Gray earns 4.8% yearly but keeps his principle when he dies. Red's investment has a much higher return but is less flexible and has a large fee at the end, while Gray's investment has a lower return but is flexible and has no fees.

When stated this way, it becomes clear that it's an interesting tradeoff. Whether or not it's worthwhile depends on how long you live and how much you plan to consume. (Just one example: if Red wanted to spend only $400/month, he could reinvest the remaining $250/month at the same rate Gray is getting, and 20 years later he'd have rebuilt his original $100k. At that point, Red could preserve his new principle and begin drawing $1050/month!)

[chynalemay]

I sold MYSELF an annuity as I was a fin planner for 15+ years before I retired! Today's new variable annuiites w/ many situational riders can offer families in different situ's a great way to access dollars AND have income! As well get your $$ back if you want to unwrap the contract/decision down the road. For me, putting ALL my tax defered $$, about 25%~ of my liquid net worth (it's gonna be orduinary income anyway) w/ a guarenteed 7% WITHDRAWAL RATE rider, annual step up's and a guaranteed return of principal - if I choose out before starting the rider(among other possibilities the contract has) allows me to "aggressively invest" in the annuity w/ no downside loss. Nvver put ALL money into one but, to supplement a social security check, military retirement and VA pension, this "4th check" gives me no loss possibility and a combined $7500+ a month at age 62 - and I'll take SS at age 62, pay it back at age 70 w/ I binds due from early this century and never worry about $$ (see prevous articles here ref SS decisions) for even MORE income later. again, almost all middle income earners should consider an annuity as a SS, and pension suppplement...nuff said!

[Plex]

Good job completely discounting the ridiculously high costs (fees, not just losing all of the principle) of annuities, which is the main reason people avoid them. It is not just trading an investment for an income source, it is more like trading a positive return investment for a fixed investment with a highly negative yearly return.

[Plex]

Also, anyone can be a "financial planner", it requires no significant certifications or education. Be wary of people like the poster above me (obviously).

[chynalemay]

BS, MBA, Registerd Principal, Registered Advisor, CFP, multiple state licenses, etc., etc., you must have SEVERAL "credentials" licenses to practice in ANY state bTW...and they all cost, require significant study and continuing education...My customers portfolio of over $135+M included the same (nameless but, from a few very large Superior rated Insurance co's) and, I'll trade MY portfolio anyday (I only worked Full-time for 25 years after college grad w/ BS i '82, care to take that bet?? HA! Sometimes in life you GET what you paid for! In my case the annuity has already paid for itself in a lifetime of very modest costs, especially in lite of the market meltdown of the past few years...I MADe money, did you?? Retired at age 47 forever!

[JeffinwesternWa]

I realize chynalmemay is right, you can get several HQ variable annuities w/ the guarantees he mentions and NEVER give up your pricipal, even at death, they work pretty good, especially for those that need/ want income, upside potential and no downside..and for deferred money like IRA's/401'Ks make sense since that "deferred money" is ordinary income anyway, my accountant recommend I look into one last time we met so I'll met w/ my advisor to do so...

[Georgie Boy]

I would have chosen mister Red's choice because if you look at the second proposition of mister Gray you see he can get his money back if he wants but if you consider the annuity he can get a month without never consumming his capital, it is only 333 $ (100 000 * 4% / 12). This isn't worth doing it.

But the first time you read it, you think yeah all right but after calculating all stuff; the choice is easy.

[rwh]

I didn't see anything "subtle" about the different way the scenarios were presented. In the first quiz the contract choices were stated in general terms. In the second quiz specific percentage returns were presented, allowing the reader to do some calculations. The second quiz provided more meaningful information than the first quiz.

Yes, the first quiz focused on how much you could spend, but the second quiz told you exactly how much was being invested as well as % return, in addition to the "subtle" difference of leading the reader in the direction of how much they would have to live on (which automatically implies choice), compared to how much they could spend.

Neither example disclosed fees.

Psychology is clearly at work here, but the examples are hardly the same in concrete terms.

[Mike Hunt]

The 2nd example didn't make sense to me. Both Gray & Red were 65 when they retired and started this example? That would mean that Gray was drawing $250 per month for 20 years into his principle before it was eaten up... Actually not completely true because the interest payment is decreasing as the principle is coming down. Well $250 per month is $3000 per year so even after 20 years he would have used $60k of his principle.

Maybe I need to put this into excel and model it but the idea is that after 30 years his principle will be exactly zero?

-Mike

[Jim]

A plain old immediate annuity is nothing bad as long as fees are not excessive. That is the kind of annuity the article talks about. Simple contract where you pay $100k today at retirement age and get $650 a month for life.

Variable annuities and abuses around them have given annuities a bad name. Variable annuities are more complex and can have various fees and options that are not clear. With a industry average of 2.4% expense ratio, plus loads and commissions a variable annuity can be a real crappy deal.