In May 2019, Brookings and the Kellogg Business School Public-Private Initiative held a conference on the subject of “Retirement Policy and Annuitization: A View from the Experts.” Three papers from that conference are available: "Can annuities become a bigger contributor to retirement security?" by Martin Neil Baily Brookings and Benjamin H. Harris (June 2019); "Automatic enrollment in 401(k) annuities: Boosting retiree lifetime income," Vanya Horneff, Raimond Maurer, and Olivia S. Mitchell (June 2019); and "Using behavioral insights to increase annuitization rates: The role of framing and anchoring," by Abigail Hurwitz (June 2019).
Instead of "life insurance," which pays out after you die, annuities are a form of "continued living insurance," which pay out as long as you remain alive. In some contexts, annuities are quite popular. For example, Social Security is an annuity-style program; that is, you pay into it during your lifetime, but at retirement, the benefits arrive in an inflation-adjusted stream of payments until death, not a one-time chunk of cash that could be immediately spent. Many workers also liked the traditional "defined benefit" pension plan, in which an employer pays into a fund that provides benefits until death. A defined benefit pension plan acts like an annuity--albeit one that is purchased and financed indirectly through an employer.
However, one of the big changes in retirement savings in the last few decades is that the classic "defined benefit" pension plan is in decline, and workers instead have a retirement account, like a 401k or an IRA, in which they have saved money for retirement. Given that the drop in consumption from outliving one's assets could be very large, economic models often suggest that people should be more willing than they seem to be to take some portion of the money in this account and use it to by annuities. The Horneff, Maurer, and Mitchell paper runs through a set of illustrative calculations, suggesting that most people would benefit if they put 10% of retirement wealth into an annuity--and many would benefit from putting in a larger share.
There aren't official statistics on how many Americans buy annuities, but studies suggest that it's probably 10% or less. So why don't people annuitize more of their retirement wealth? There are a number of possible explanations.
Baily and Harris point out that people often tend to use "mental accounts": for example, they think of certain income as being available for short-term consumption, or medium-term savings (say, for home repairs or a vacation), or for retirement savings. Many people think of the retirement savings in their 401k or IRA as their own spending money that they control, not as money that should be used to purchase "continuing life insurance" via an annuity. (In contrast, most people don't think of Social Security or defined pension benefits as their personal money in the same way; instead, people have already mentally handed off the control over those funds to a government or employer account.)
Another issue is that people worry that they will buy an annuity but then die quickly and "lose" money on the transaction. I think of this as a standard problem with every form of insurance. Most insurance--life, health, car, home-- pays off when something bad happens and you need to make a claim. In a way, the best outcome is that I spend my lifetime paying for all these forms of insurance, and never end up using any of them. But of course, if I never make a claim on my insurance, I feel as if I wasted the money, because the risks never actually happened. Indeed, what I sometimes call the "unavoidable reality of insurance" is that there will be a relatively small number of people who get large insurance payouts--and they are the unlucky ones because something bad happened in their lives. The "lucky" ones pay and pay and pay those insurance premiums, and almost never get anything back. No wonder insurance is often unpopular! And it's no wonder that many people often obtain insurance under some form of pressure: you need car insurance to drive your car, and you need home insurance to get a mortgage, and your employer provides health insurance as part of your job compensation, and you are required by law to pay into Social Security or Medicare. With annuities, the fear is that you might be buying one more form of insurance that won't pay off.
Yet another issue is that annuities can be complex financial contracts, and hard for an average person to evaluate. How long do you pay into the annuity? When does it start paying out? Does it pay our for a fixed period, or over the rest of one's life? Are the payouts adjusted for inflation? How large a commission is being charged by the seller? Does the annuity include a minimum payout if you die soon--which could be left to one's heirs? What happens if the company that sold you the annuity goes broke a decade or two in the future? How will the tax code treat income from annuities in the future? In the past, some annuities were not an especially good financial deal, in the sense that someone with the discipline to withdraw money from their retirement accounts in a slow-and-steady way have a high probability of ending up better off than someone who purchased a life annuity.
What might be done to tip the balance, at least a little bit, toward more people buying annuities?
One option is a "nudge" approach in which the default approach would be that a small proportion of retirement accounts would be automatically annuitized at retirement. A body of social science research suggests that lots of people would just go with the default approach, and would end up being pleased that they had done so. But anyone who didn't want this default to happen and didn't want teh annuity could opt out with a phone call. Annuities are a default option in Switzerland, for example.
Another option is to offer a different framing of the choices. For example, instead of "buying an annuity" perhaps there should be an option to "buy higher Social Security benefits for the rest of your life." Some survey evidence suggests that when annuities are described in terms like "spend" and "payment," people are more attracted than if they are described by terms like "invest" and "earning." It would probably also be useful if the presentation of annuities could be standardized, so potential consumers could more easily compare what they are buying.
There are some interesting international comparisons discussed in the Hurwitz paper. She writes: "The United Kingdom had a mandatory annuity law that was repealed in 2014. The Netherlands mandates full annuitization, Chile offers only annuities or phased withdrawals, Israel adopted a mandatory minimum annuity requirement in 2008 ..." There is some evidence that when annuities have become more common in a country, then people often keep on choosing them even if the default or requirement to do so is loosened.
For a couple of previous posts on the "annuities puzzle," see:
- "Life Expectancy Risk and Annuities" (November 11, 2014)
- "Underpurchasing of Annuities" (November 23, 2011)
