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Behavioural reasons why we ignore life annuities

In Cuffelinks 32, I explained that life annuities have merit for people who seek to smooth their consumption over a lifetime of unknown length. And yet we find little annuitisation in Australia or around the world, and so we have an ‘annuity puzzle’. In Cuffelinks 34, I explained some of the rational challenges to annuities, but well-respected academics such as Jeffrey Brown find it difficult to accept that the lack of annuitisation can be explained solely by rational reasons. In this article I outline a number of behavioural reasons why people may not purchase life annuities.

This article heavily references Jeffrey Brown’s work in his paper Rational and Behavioural Perspectives on the Role of Annuities in Retirement Planning but much of this stems from broader behavioural finance research by the likes of, among many others, Richard Thaler and Shlomo Bernartzi, and ultimately, Nobel Prize winner Daniel Kahneman.

Complexity and financial literacy. There are many research papers which demonstrate the lack of financial literacy across the population. Lifecycle modelling is highly complex and most people would not be capable of making an accurate assessment of retirement needs, even if they have reasonable levels of financial literacy (though of course they may seek advice). Uncomfortable that a decision is beyond their understanding, an individual may be anchored to the status quo (inertia), namely the default option. This has greater resonance when the active decision to purchase an annuity is one which is not always reversible, though some life annuity contracts now allow an exit within a fixed time period. For super fund money the default option is typically an allocated pension product but one can quite easily redeem and take a lump sum. A life annuity is nowhere in sight when it comes to default retirement solutions.

The power of defaults cannot be underestimated. Defaults, depending how they are framed, can potentially be interpreted as a recommendation by the company. And defaults often persist for individuals because to move away requires an active decision. An example is the Swiss pension system where an annuity is commonly the default at retirement (with an ability to take a partial and sometimes full cash lump sum), and annuitisation rates are extremely high.

Mental accounting and loss aversion. In US focus group research, people viewed the purchase of a life annuity as ‘gambling on their lives’. This doesn’t fit with the rational reasons for purchasing life annuities, namely the guarantee of an outcome and the removal of the risk of unknown lifetimes. In effect, Brown suggests that the mindset of consumers with respect to annuities is behaviourally influenced rather than completely rational.

Brown suggests that an individual may view insurance differently to an economist. Where an economist views an insurance contract as a way to manage a risk, an individual may frame an insurance contract as a payment to counter a bad event. Yet many people may not view living a long time as bad, so they would not view annuities as attractive. Surely education and advertising can be used to persuade people that living a long time without sufficient means is bad.

Regret aversion. Consider the scenario where someone purchases a life annuity and then discovers they are terminally ill. Not only are they distressed about their life coming to an end but they will also have great regrets that they purchased a life annuity. The fear of experiencing this regret may be a deterrent to annuitise.

Loss of control. This can be considered in a rational framework (annuitisation leads to a loss of liquidity as one exchanges wealth for an income stream) but also from a behavioural perspective. Brown refers to psychology literature on the ‘illusion of control’ where greater control over the financial future is gained from accessible wealth. My feeling would be that the rational reason (loss of flexibility, counterparty exposure etc) is a stronger reason which can be explored further.

Framing. Framing refers to how information is communicated to us, and how it affects the decisions we make. A simple example could be a treatment for serious illness, where one description may be “taking this treatment will give you a 30% chance you will live”, while another is “taking this treatment will leave you with a 70% chance of death”. The way annuities are framed may affect their level of acceptance by investors. Unfortunately, annuity providers are likely to encounter entrenched views of annuities as negative and it will take time to counter such broadly-held prejudices.

And so the annuity puzzle remains unsolved – there remains no seminal piece of research which reconciles why a product which has theoretical appeal does not gather significant market acceptance. Further work is needed on both rational and behavioural reasons, as well as the interaction between the two. While behavioural research always sounds exciting, in my experience it is easier to display the direction of an effect more than quantify its impact.

In the meantime addressing obvious rational impediments (eg. irreversibility, money’s worth transparency, supply side impediments, barriers to product innovation, and the issue of counterparty risk) as well as continued focus on the way the product is framed to individuals (managing the risk of living a long time poor) can only improve the small signs of growth in life annuity sales in the Australian market.

David Bell’s independent advisory business is St Davids Rd Advisory. David is working towards a PhD at University of NSW.

Terry McMaster
October 29, 2015

It could be simpler than this.

It could be that the rate of return is too low, and the risk of losing the real value of the annuitant's capital over time is too high, such that a rational conservative adviser would not recommend annuities to a client, because it would not be appropriate to the client or in the client's best interests.

Harry Chemay
October 24, 2013

David, another 'trilogy' of great merit, to back up your equally impressive trilogy of articles on real return investing.

The annuity puzzle remains a retirement income policy conundrum not just here in Australia but across much of the developed world, burdened as we all are with rapidly ageing populations and deteriorating dependency ratios. For the myriad of rational and behavioural reasons you outline, individuals, when assessing the potential merits and costs of annuitizing, come to the conclusion that there is more downside than upside built into these products.

To my mind behavioural drivers appear to dominate decisions to annuitize made by 'typical' retirees. And by typical I mean ones that do not have an actuarial or finance background.

The two drivers that tend to come to the fore when annuities are considered are loss of control and mental accounting. I find the behavioural literature around the 'illusion of control' to be entirely feasible. Individuals do indeed put a premium on accessible wealth, and appear unwilling to sacrifice liquidity to gain income certainty. In the minds of many, a lifetime annuity results in nothing other than the removal of a capital lump-sum from their mental wealth balance sheet. Thereafter it can neither be accessed nor borrowed against, a lose-lose proposition to the typical retiree.

It is becoming increasingly apparent that individuals appear to remove the capital allocated to lifetime annuities from their mental accounts even though the income stream purchased is an asset, the present value of which should be included 'on balance sheet'. The mental arithmetic is just too hard. People love seeing large numbers on their mental balance sheets, and will avoid investments that don't show up on them. This phenomenon is coming to be known as 'the Scrooge McDuck effect'.

So if mental accounting and the loss of control are difficult behavioural biases to overcome, what can be done to encourage more Australians to take longevity risk more seriously? Financial literacy is one answer, but it has to be literacy at both the planning professional and end-investor levels.

The other is government policy. It should be remembered that Australia did actually have a thriving annuity industry, led by the big life assurance companies and their dominance of Australia's financial landscape before deregulation of the banking sector in the 80s and the introduction of the Super Guarantee in 1992.

The key policy support for lifetime annuities however came from the social security legislation. Until 19 September 2004 every dollar invested in a 'complying income stream' (which included lifetime and long-term annuities) received a 100% exemption from the Age Pension asset test. This from an AFR article in August of that year. "Challenger Financial Services Group sales figures highlight the voracious demand for annuities at the moment. Its sales have almost doubled in the past five weeks and are triple its sales for the same time last year."

From 20 September 2004 the asset test exemption for complying annuities was cut to 50%. Annuity sales have been on a steady decline ever since, and were further eroded by the complete removal of the asset test exemption for purchases made after 20 September 2007. Clearly the 'good' provided by the promise of a higher age pension was sufficient to overcome the 'bad' aspects of annuitization.

It is therefore possible to overcome inherent behavioural biases against annuitization, but only with the assistance of supportive policy settings. The current debate about removing the impediments to the development of deferred annuity products is a step in the right direction.

As Richard Thaler and his colleague Cass Sunstein posit in their book 'Nudge: Improving Decisions about Health, Wealth, and Happiness', government policy has a large part to play in the 'choice architecture' that shapes individual decision making. Not so much Adam Smith's 'invisible hand' of free market forces but a policy-based 'guiding hand' to help overcome our inherent sub-optimal decision making where retirement is concerned.

Geoff Walker
October 21, 2013

Great point, Michael. The first thing needing to be done is to point out that for those investors focused on security of income rather than security of capital, a key assumption of the Capital Asset Pricing Model, namely that investors evaluate portfolios by looking at the expected returns and standard deviations over a one-period horizon, does not apply to them.

Therefore Modern Portfolio Theory's conclusions depending on this assumption do not apply to them and so they can perfectly logically ignore its dictums about volatile assets being risky assets. The received academic wisdom is largely irrelevant to these investors for whom Australian shares, generating a growing dividend stream, are much closer to a risk-free asset than Government bonds, which offer no ability to maintain real income over time.

Michael Langtry
October 21, 2013

I would like to see better promotion and education about the value of REGULAR investment INCOME.
I'm pleased to see this sort of discussion including David Bell's articles, because it helps inform and educate.
I have found that if I can get retirees to focus on security of income instead of security of capital, they are more inclined to invest in high quality long term investments. This is preferable to the more common attitude of emphasizing the potential for capital gain when selecting investment strategies for retirees. Is there some way we can foster a more informed and useful debate for investors?
(Editor comment: Michael will be writing a longer version of his comments based on experience at the 'coal face' soon).


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