Can the Personal Pension Leverage Behavioral Economics to Solve the Annuity Puzzle?

Published April 9, 2018
The Personal Pension, which is an annuity account that you fund over time through small monthly contributions, addresses many of the behavioral economic causes of the annuity puzzle.
  • The annuity puzzle is the phenomenon that shows annuity adoption to be less than would be expected, considering that economists have demonstrated that purchasing an annuity can lead to higher retirement income than a self-managed portfolio
  • The cause of the annuity puzzle can partially be linked to key behavioral economic concepts, such as that people don’t make strictly rational economic decisions
  • By allowing you to slowly purchase retirement income over time, the Personal Pension uses learnings from behavioral economics to improve your retirement security

The Annuity Puzzle

Economics provides us with a framework to understand and predict people’s motivation and behavior. Within this framework, we expect people to act in their universal self-interest. Because annuities reduce longevity risk through guaranteed, lifetime income, traditional economics would expect that these products would have extensive adoption. Data shows that retirees are hesitant to purchase annuities, despite the clear rational benefits of doing so.

This is called the “annuity puzzle.”  Researchers investigating the “annuity puzzle” have cited behavioral economics as a possible explanation, with some going as far as to encourage the government to pass laws that mandate retirement plans provide annuitization. Understanding certain core behavioral concepts can provide insights into solving the annuity puzzle.

Present Bias

Present bias refers to people’s general preference for payoffs today compared to a financially equivalent payoff tomorrow. This is a real life situation that retirees face as they decide whether to keep their retirement savings accessible as a lump sum vs. try to spread out their savings over the duration of their retirement. Due in part to present bias, retirees choose not to “lock-up” some of their nest egg in an annuity, even though doing so reduces longevity risk and allows for consistent income and spending. Even worse, many retirees elect to “cash out” their pensions at retirement, despite the significant costs of doing so.  

Hyperbolic Discounting

Building off of the concept of the time value of money, the internal rate of return (IRR) is the interest rate at which someone should be indifferent between a financially equivalent payoff today compared to a payoff in the future (i.e net present value is 0). In behavioral economics, however, people require a higher interest rate for a future payoff than the IRR would predict, meaning people are willing to accept a much smaller reward today in-lieu of a larger reward in the future. In the annuity market, this means people feel too much “pain” – or disutility – for every dollar used in the purchase of annuity and too little “reward” – or utility – for future lifetime payments. Thus, people opt against purchasing an annuity because they too heavily discount future annuity payouts by overweighting the value of the money today.

Risk Aversion

Risk aversion refers to people’s tendency to overweight potential risks and losses compared to gains, even if they are properly compensated for these risks. As a result, people are less inclined to select an option that has the possibility of some form of loss even if, overall, it’s economically advantageous. This often leads to people disproportionately preferring “safer” options, as they limit the likelihood that they feel the pain of a loss.

Because of the way annuities are described, people often evaluate them within an “investment framework” (read more here). In this frame, annuities are investments where the return on investment increases as a person lives longer. Here, people “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.”

Instead, if one looks at annuities through the “consumption framework,” they’ve generally viewed more attractively. In this framework, individuals are less concerned with the return on investment and instead focus on their experience in retirement, specifically, their ability to consume goods and services. With this mindset, annuities provide a clear path to meeting one’s goals in retirement.

How the Personal Pension Can Solve the Annuity Puzzle

The Personal Pension is an annuity account that you fund over time through small monthly contributions. Before you enroll, you decide how much income you need every month in retirement and at what age you want it to start. This Personal Pension guarantee ensures that lifetime annuity income is available to you and is made possible by the pooling of risk across millions of Americans.

The Personal Pension approach to purchasing annuity income solves numerous behavioral pain-points. By spreading out your annuity purchase over a series of purchases, the Personal Pension is able to reduce people’s present bias (after all, you are sacrificing less money today). Additionally, the Personal Pension uses hyperbolic discounting to its advantage by making the “pain” of committing to future payments feel “cheaper” today. As a result, behavioral economics would predict that purchasing annuity income via the Personal Pension “feels” better than purchasing an annuity through a one-time upfront payment. The Personal Pension annuity also provides a refund at death by default so that you are guaranteed to at least get your money back, even if you die.

Blueprint Income offers a Personal Pension account with the lowest minimum, $5,000. After opening an account, you can make subsequent contributions of as little as $100, each of which will increase your income check. See below what regular contributions into the Personal Pension would look like for you:

 

To customize your own Personal Pension and sign up, head to the Personal Pension Builder.

 

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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.