The Decision to Annuitize: Reconciling Economic Theory and Consumer Behavior Using Behavioral Economics
These three articles attempt to find explanations for the annuity puzzle, or the divergence between economic theory, which suggests that consumers should choose annuities because they are welfare optimizing, and actual consumer behavior, which shows that consumers opt to receive their retirement benefit in the form of a lump-sum payment rather than in an annuity. The first article, “Rational and Behavioral Perspectives on the Role of Annuities in Retirement Planning,” offers numerous hypotheses, rooted in behavioral economics, that could potentially explain the annuity puzzle. The latter two articles, “Cognitive Constraints on Valuing Annuities,” and “Behavioral Impediments to Valuing Annuities: Evidence on the Effects of Complexity and Choice Bracketing,” address the annuity puzzle using experiments involving internet survey respondents who were subjected to hypothetical questions surrounding the annuitization decision. The common theme among the three articles is that they offer a deeper analysis of the annuity decision outside of the traditional classical economic framework by examining the role of behavioral factors, which move away from assumptions of complete rationality, along with psychological factors in explaining the annuity puzzle, and focus on how an understanding of these factors could improve the way the annuitization decision is framed in order to increase annuitization.
Life annuities are a retirement benefit in the form of a series of payments made at fixed intervals that continue as long as the benefit holder is alive. Life annuities reduce the risk of outliving one’s assets. Furthermore, economic theory suggests that, relative to receiving a retirement benefit in the form of a lump sum—that is, a single, full payment—life annuities increase the welfare of individuals by reducing the financial risks associated with outliving one’s assets. Empirical evidence suggests that the value consumers place on annuities is not consistent with economic theory, however. At the time of the research, the articles note that the private market for annuities was small, and the group market (employer-sponsored plans) has been declining, leaving the Social Security system as the most significant source of annuities in the United States. In “Rational and Behavioral Perspectives on the Role of Annuities in Retirement Planning,” Jeffrey Brown attempts to explain the divergence between theory and actual consumer choice by offering several hypotheses rooted in behavioral economics.