Theoretical models of rational human behavior predict that individuals retiring will purchase annuities to protect themselves against running out of funds; yet only a minority own annuities – an issue known as “The Annuity Puzzle.”
An annuity is a contract between an insurance company and an individual to provide them with guaranteed lifetime income, in exchange for an upfront lump sum payment. An annuity should therefore appeal to anyone concerned about outliving their savings; yet many retirees still resist annuitization despite record sales figures and favorable regulations over recent decades.
Economists have been laboriously trying to explain this anomaly. They have labeled people who choose not to buy annuities as “irrational,” suggesting there could be complex reasons behind their decision not to purchase. But most people who avoid annuities do not act irrationally; instead they consider countervailing forces that economists often fail to consider.
One such force is ambiguity aversion: as more outcomes become possible, individuals’ marginal utility from consumption drops; this leads them to favor holding more cash or short-term assets versus investments that offer steady stream payments such as an annuity contract.
Anthenizing is hindered by perceptions of high fees and expenses associated with fixed annuities, yet evidence shows these are much lower than anticipated; recent research even suggests zero annuitization may be optimal for individuals with moderate bequest motives at available rates.
An additional consideration is that many retirees already have other sources of inflation-adjusted lifetime income support such as Social Security or personal savings with tax-deferred growth; annuities may therefore no longer be necessary as protection against longevity risk.
Understanding annuities is vitally important for both retirees and financial planners alike, especially as the retirement years approach. Retirees need to know that annuities provide an effective method for creating secure income streams in retirement, while financial professionals must be able to explain this fact clearly to their clients. Financial professionals must recognize that annuities do not fit all clients and should offer customized options to address each one. Individuals who are focused on bequesting may find an annuity with features like period-certain guarantees beneficial, which help minimize longevity risk exposure. Financial professionals and policymakers who possess an advanced understanding of annuities can collaborate to design products and educational materials to assist retirees in adopting annuities as part of their retirement income strategies.