The Value of Annuities vs. Lump-Sum Payments for Retirees
There are several different kinds of insurance products known as annuities that can provide regular income for a retiree. For example, life annuities or lifetime annuities provide income for life, and hence insure retirees against longevity risk, which is the risk someone will outlive their accumulated financial assets.
This insurance is extremely valuable for the annuitant, and standard economic models predict that retirees should spend a substantial portion of their assets on buying life annuities. In spite of that prediction, though, the size of the private market for life annuities is relatively small. Economists call this mismatch the annuity puzzle. One common explanation for the annuity puzzle is adverse selection: the people who most need protection from longevity risk—such as those with good health and so presumably longer lives—are the same people who are more likely to purchase life annuity products: the number of payments the annuitants will receive depends on the number of years they live. The insurers internalize this adverse selection of customers and set a relatively high price for all potential customers. This leads to a price that is too high for the average retiree and so limits the number of people who will find it convenient to purchase the product—and thus to fewer people ultimately buying annuities.