Can We Solve the Annuity Puzzle by Reframing Annuities?

Published April 9, 2018
Annuity adoption is less than would be expected in traditional economic models, as economists have shown that purchasing an annuity can lead to higher retirement income than a self-managed portfolio. Reframing annuities as a mechanism to improve consumption in retirement can improve utilization of annuity products.
  • The annuity puzzle is the phenomenon that shows annuity adoption to be less than expected, as economists have shown that purchasing an annuity can lead to higher retirement income than a self-managed portfolio
  • Reframing annuities as products that increase consumption in retirement may lead to greater usage of annuities
  • The Personal Pension utilizes the consumption frame to help people plan for retirement by purchasing guaranteed, lifetime annuity income over time in small increments

The small overall annuity market within the United States is sometimes linked to certain behavioral economic causes. This has led to the underutilization of annuities despite the greater amount of lifetime income provided by the product compared to self-managed accounts. This phenomenon is called the annuity puzzle. While earlier posts discussed how the Personal Pension, an annuity account that you fund over time through small monthly contributions, can address certain behavioral economic pain-points inherent in annuities, the overall annuity market may remain underutilized because of framing issues. By Reframing annuities as a product that increases consumption, people may be more inclined to purchase these products, thereby fixing the annuity puzzle.   

Investment Framework

The investment framework portrays annuities as an option for investment alongside bonds, stocks, and other places one can park their money. Included in this frame is the concept that annuities have a rate of return that can be projected ex-ante, through the use of mortality tables and average life expectancy, or calculated ex-post at the end of the annuitant’s life. In this frame, annuities provide an uncertain return to investors, as individuals are unsure about the number of monthly payments that they will receive (they only know that they will receive monthly payments for the duration of their life). Here, annuities are an investment where investors “lose” by dying too soon and “gain” by living longer. Due to risk aversion, many people may be hesitant to invest in an annuity because they are concerned that they may die too soon, thereby incurring a “loss”.

Consumption Framework

In 2013, a landmark paper by Jeffrey R. Brown, Jeffrey R. Kling, Sendhil Mullainathan, and Marian V. Wrobel found evidence that supported the hypothesis that annuities are subject to framing effects. Specifically, annuities appear more desirable when consumption is emphasized compared to when investment is emphasized. Under some scenarios within the survey, respondents preferring an annuity to an alternative investment option increased from 21% under an investment framework to 72% in the consumption framework.

In this frame, annuities allow for smooth, lifelong, consumption in retirement. Via consumption smoothing, annuities allow aging retirees to preserve spending at later stages in life where other retirees may have to reduce consumption in order to avoid outliving their retirement savings. In this frame, annuities, which guarantee lifetime income, serve as a form of longevity insurance by reducing the risk that people outlive their money in retirement. 

When viewed through the consumption framework, annuities are far more attractive to pre-retirees.

Reframing Annuities to Solve the Annuity Puzzle

By transitioning the lexicon of annuities to a consumption framework, annuities become easier to understand and more interesting to consider. Reframing annuities can be done, in part, by encouraging people to think of their retirement savings in the context of income generation and to take actions in order to protect that income. The Personal Pension, which is a lifetime annuity that is purchased over time in small increments, does this as part of the sign-up process. Prior to enrolling in the Personal Pension, people decide how much income they need every month in retirement and at what age they want it to start.

With a focus on the amount of monthly income needed at retirement, the Personal Pension helps spread out acquiring this income into smaller incremental payments. Over time, people can see how much guaranteed, lifetime annuity income they have accumulated. This guaranteed, lifetime income means people won’t have to worry about “cutting back” or skimping in retirement. What’s more, with an annuity, spending a dollar in retirement doesn’t have to be a chore. While people with self-managed accounts have to worry about the trade-off of spending a dollar today vs. investing that dollar for the future, annuitants can live with the confidence that they can count on receiving a monthly check for the rest of their life. 

Learn more about how the Personal Pension can help you enjoy retirement and see what it could look like for you below.

 

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Lauren Minches

Lauren Minches

Financial Planning Professional

Lauren is an actuary by training with expertise in retirement, finance, and risk. She writes about annuities to make them easier to understand and evaluate. Her goal is to help people create retirements with more time for living and less time thinking about money.