Complexity as a Barrier to Annuitization: Do Consumers Know How to Value Annuities?

50 Pages Posted: 4 Apr 2013

See all articles by Jeffrey R. Brown

Jeffrey R. Brown

University of Illinois at Urbana-Champaign - Department of Finance; National Bureau of Economic Research (NBER); University of Illinois College of Law; University of Illinois at Urbana-Champaign - Institute of Government and Public Affairs (IGPA); University of Illinois at Urbana-Champaign - Department of Economics

Arie Kapteyn

Dornsife Center for Economic and Social Research - University of Southern California; IZA Institute of Labor Economics; National Bureau of Economic Research (NBER)

Erzo F. P. Luttmer

Dartmouth College; National Bureau of Economic Research (NBER); IZA Institute of Labor Economics

Olivia S. Mitchell

University of Pennsylvania - The Wharton School; University of Pennsylvania - The Wharton School, Pension Research Council; National Bureau of Economic Research (NBER)

Date Written: March 1, 2013

Abstract

This paper provides experimental evidence that individuals have difficulty valuing annuities, and this difficulty – rather than a preference for lump sums – can help explain observed low levels of annuity purchases. Although the median price at which people are willing to sell an annuity is close to median actuarial values, this masks notable heterogeneity in responses including substantial numbers of respondents whose responses are difficult to reconcile with optimizing behavior under any reasonable parameter assumptions. We also discover that people are willing to pay substantially less to buy a larger annuity, a result not due to liquidity constraints or endowment effects. Strikingly, we also learn that individual responses to the buy versus sell decisions are negatively correlated, an effect that is stronger for the less financially sophisticated. Our findings are consistent with boundedly rational consumers who adopt a “buy low, sell high” heuristic when faced with a complex trade-off. Moreover, at the margin, subjective valuations vary nearly one-for-one with actuarial values but are uncorrelated with utility-based measures designed to measure the insurance value of annuities. This supports the hypothesis that people use simplifying heuristics to think about annuities, rather than engaging in optimizing behavior. Results also underscore the difficulty of explaining the cross-sectional variation in annuity valuations using standard empirical models. Our findings raise doubt about whether most consumers can make optimal decisions about annuitization.

Suggested Citation

Brown, Jeffrey R. and Kapteyn, Arie and Luttmer, Erzo F.P. and Mitchell, Olivia S., Complexity as a Barrier to Annuitization: Do Consumers Know How to Value Annuities? (March 1, 2013). Pension Research Council WP 2013-01, Available at SSRN: https://ssrn.com/abstract=2243616 or http://dx.doi.org/10.2139/ssrn.2243616

Jeffrey R. Brown

University of Illinois at Urbana-Champaign - Department of Finance ( email )

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National Bureau of Economic Research (NBER) ( email )

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University of Illinois College of Law ( email )

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University of Illinois at Urbana-Champaign - Institute of Government and Public Affairs (IGPA) ( email )

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University of Illinois at Urbana-Champaign - Department of Economics ( email )

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Arie Kapteyn

Dornsife Center for Economic and Social Research - University of Southern California ( email )

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IZA Institute of Labor Economics

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Erzo F.P. Luttmer

Dartmouth College ( email )

Department of Economics
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United States

National Bureau of Economic Research (NBER)

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IZA Institute of Labor Economics

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Olivia S. Mitchell (Contact Author)

University of Pennsylvania - The Wharton School ( email )

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United States

University of Pennsylvania - The Wharton School, Pension Research Council ( email )

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