Wednesday, November 23, 2011

Underpurchasing of Annuities

Outliving your wealth is a frightening idea for any retiree. An obvious answer is to annuitize some of that wealth, thus guaranteeing a stream of future income for life. In the most recent issue of my own Journal of Economic Perspectives, Shlomo Benartzi, Alessandro Previtero, and Richard H. Thaler make the case that not enough people are annuitizing enough of their wealth "Annuitization Puzzles."

As a starting point, instead of thinking about life expectancy as a point estimate, think about it as a distribution. The authors look at the distribution of life expectancy at age 65 and explain: "There is a 22-year difference between the 10th and 90th percentile of the distribution for men (dying at 70 versus 92). Similarly, there is a 23-year difference between the 10th and 90th percentile of the distribution for women (dying at 72 versus 95). In other words, one in ten men retiring at 65 might expect to live another 27 years, and one in ten women can expect to live another 30 years. These numbers give a sense of the potential magnitude of the risk of outliving one’s retirement wealth. Of course, annuities are a straightforward way to hedge longevity risk." Here's an illustrative figure:

Of course, any given person might have some knowledge based in family history or lifetime health patterns that helps them to predict their life expectancy within this distribution. Still, looking at average experience suggests that at least some people, perhaps many people, are not annuitizing as much as they should. The authors write: "For men, life expectancy at age 65 has increased from 12.8 years to 16.6 from 1950 to 2010, an increase of nearly 30 percent. Since saving rates have also fallen, it ishard to see how Americans are rationally planning to fund this extended period ofretirement—which suggests that some of them are making a mistake." Again, here's an illustrative figure.

The authors consider a number of possible reasons why people don't annuitize more: for example, the difficulties of shopping for an annuity, the pain of writing that big check to buy an annuity, and other reasons. They cite research that people tend to like an annuity more if it is sold a providing assured consumption of (sat) $650/month for life, but to like the same annuity less if it is sold as providing an investment return of $650/month for life. To many people, guaranteeing consumption sounds safe and reassuring, but an investment return sounds risky and uncertain.

But the also point out that many Americans have a very easy way to annuitize much more of their lifetime wealth: that is, work a few years longer before they start claiming Social Security benefits. Benartzi, Previtero, and Thaler offer a nice example that's due to Jeff Brown: "Individuals are allowed to start claiming Social Security benefits as early as age 62 but do not have to begin claiming before turning age 70. As one waits longer before claiming benefits, those benefits are adjusted upward in an actuarially fair manner. This choice effectively means that by delaying the onset of benefits, participants can buy, at better-than-market prices, a larger annuity, and one that is indexed for inflation and offers survivor benefits. If one wants to buy an annuity at a good price, this is an excellent way to do it. But few participants avail themselves of this opportunity. Most people begin claiming within a year of becoming eligible, and less than 5 percent delay claiming past age 66."

Thus, the easiest way to encourage greater annuitization is to encourage it through the Social Security system, where these issues of adjusting benefits upward in an actuarially fair manner are often not well-understood. An additional step would be to help design 401k and other defined contribution retirement plans so that there is a clear and attractively phrased annuity option available.