There is much to recommend in purchasing an annuity at retirement to manage the risks and uncertainty of longevity. It’s well known though that surprisingly few people who have the option to purchase an annuity do so.
Richard Thaler presents some of the common perception problems with annuities in this article in the NY Times. The basic message is still as it has been for decades. Individuals are reluctant to pay a large portion (often the majority) of their life savings to an insurer with the risk that they will die in a few years and “not have got their money back”. The peace of mind that should come to the policyholder turns into a matter of stress.
The bequeath motive is strong – and amplified by a lack of understanding of exactly how long we’re likely to live in retirement these days and how much money will be required. Those to whom many plan to bequeath may ultimately become the source of support when the income draw-down products are depleted with no longevity guarantee to boost the funds available.
It’s a good explanation although he doesn’t break much new ground. He also doesn’t talk about the concerns some potential policyholders have, in some countries at least, of whether the insurance company who sells the annuity will definitely be around over the next 40 years come what may. This is more common in developing markets with weaker regulation (probably a good reason to have concerns) and less history of annuities (a cultural bias that will probably disappear over time).
Mr Thaler doesn’t propose any solutions for the insurers in boosting sales – a common “fix” is to combine a traditional pay-until-death annuity with a guaranteed minimum period or a death benefit (either for a limited term or at any point). These adjustments reduce the “risk” of “making the wrong decision but purchasing an annuity but only living for a short period”.
There’s no free lunch. In the same way that cash-back bonuses on short-term insurance products actually increase the average cost of insurance and reduce the risk-transfer from insured to insurer, these guarantee periods increase the cost of annuities.