Policies to Increase the Popularity of Lifetime Annuities
Although lifetime annuities offer a secure income stream that is to a large degree free from investment risk, longevity risk, and—in some cases—inflation risk, annuitization rates continue to be low, a phenomenon known as the annuity puzzle. Some of the reasons for this phenomenon—such as bequest motives, potential for other investment opportunities, and the desire for liquidity—are due to the inherent nature of lifetime annuities and the environment they operate in. However, policymakers can, to some degree, abate the effect of some other reasons for low annuitization rates. These other reasons include relatively high annuity prices, which are partially attributable to adverse selection; the presence of behavioral biases; and the way annuities are framed. Specifically, adverse selection in the life annuity markets manifests itself through those perceiving themselves as having higher-than-normal longevity being more likely to purchase life annuities. This has the effect of increasing annuity prices, which then causes potential annuity purchasers to become even more skewed toward individuals who expect to live a long life, which then contributes to a spiral leading to even higher annuity prices.
People tend to be more concerned about preventing the loss of wealth than they are about gaining more wealth, and have a tendency to place too much emphasis on small risks and to discount high risks. These human biases negatively affect annuity demand due to comparatively minor risks that are inherent in annuities—such as the risk of a significantly early death and the subsequent loss of funds that had been invested in the annuity, or of the provider defaulting on annuity payments. Retirement investors who would otherwise be in the annuity market tend to give a disproportionate amount of weight to these risks.