Cognitive Constraints on Valuing Annuities

99 Pages Posted: 13 Nov 2014

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: October 1, 2014

Abstract

This paper investigates consumers' difficulty in valuing life annuities. Using a survey-based experiment, we show that the prices at which people are willing to buy annuities are substantially below the prices at which they are willing to sell them. This finding is not a simple endowment effect, because it prevails even when the annuity and lump-sum option are both presented as deviations from their own endowments. We also find that buy values are negatively correlated with sell values, as those individuals who express the highest sell values tend to also express the lowest buy values. This sell-buy valuation spread is negatively correlated with cognition; that is, the spread is larger for those with less education, weaker numerical abilities, and lower levels of financial literacy. Our evidence contribute to the emerging literature on heterogeneity in financial decision-making abilities. Importantly, it implies that many people lack the cognitive skills required to manage their retirement asset decumulation decisions optimally.

Keywords: annuity, retirement income, Social Security, financial literacy, cognition

JEL Classification: D14, D91, G11, H55

Suggested Citation

Brown, Jeffrey R. and Kapteyn, Arie and Luttmer, Erzo F.P. and Mitchell, Olivia S., Cognitive Constraints on Valuing Annuities (October 1, 2014). Pension Research Council WP 2014-21, Available at SSRN: https://ssrn.com/abstract=2523596 or http://dx.doi.org/10.2139/ssrn.2523596

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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