The annuity puzzle refers to the fact that few people choose to annuitize even a portion of their accumulated savings even though they have many good and rational reasons to do so. Psychological and behavioral barriers are key factors that affect decisions involving annuities, retirement finances, and retirement planning. Harvard professor Roland Fryer addressed some of these behavioral biases during a recent speech in New York City.
Professor Fryer provided the keynote address at the annual NAVA marketing conference that was recently held in New York. NAVA—The Association for Insured Retirement Solutions—is an organization dedicated to promoting the growth, acceptance, and understanding of annuity and variable life insurance products.
Professor Fryer, a former college football player at the University of Texas, is a rising star in the world of economics and his research at the University of Chicago contributed to the bestseller Freakonomics. Some of Professor Fryer’s current activities involve efforts to “market” education to kids in some of the toughest schools in New York City who have essentially opted out of the educational system. The marketing efforts of Professor Fryer’s team focus on messaging, information and the “rebranding” of education. The messaging and rebranding are intended to chip away at the prevailing notions (e.g. “school is not cool”) and natural psychological biases that the kids have regarding education.
For example, Professor Fryer’s team partnered with Nike to provide 1 million cell phones to 3,000 kids in the NYC school system. The objective is not to enable the kids to communicate with one another, but rather to pump information and messaging (e.g. “smart is the new cool”) to these kids about the value of education and the power of education to change their lives.
The world of annuities is filled with obstacles that are similar to those that Professor Fryer’s team faces in education. To begin with, there is very little good consumer information about annuities. Annuities are very complex and opaque products. Transparency of annuity prices and product features pales in comparison to most other industries, and comparison shopping for annuities is all but non-existent. As a result, consumer awareness of annuities is extraordinarily low. Most people are simply not aware of: what an annuity is, the basics of how they work, or of the many powerful benefits of annuities. This is a fundamental obstacle for the industry.
Messaging is also an issue in the annuity world. Let’s face it, annuities generally receive a bad rap. For the most part, the popular financial services media seems to exist in one of two states when it comes to annuities: they are either negative or they ignore the products entirely. Consumers are left with the general impression that all annuities are inflexible, expensive insurance products sold inappropriately by commissioned salespeople who are not to be trusted. This is a distorted message that results in an unfortunate disservice to consumers. The message likely prevents people from being more curious and proactive about at least understanding the basics of how annuities might be useful. A good financial advisor can be helpful in correcting the message for individual clients, but not necessarily in affecting the mass perception.
Similar to education, natural psychological or behavioral biases are real obstacles for would be annuity purchasers. For example, people have a powerful and fundamental aversion to loss. This is often referred to as “loss aversion” or “risk aversion.” Although irrational, people on the whole dislike losses twice as much as they like gains.
Loss aversion would come into play when considering the purchase of certain types of annuities such as a single premium immediate annuity that involve a single premium payment rather than a series of premium payments over time. In other words, a situation where a person might—to use a highly simplified example—provide $500,000 to an insurance company in exchange for a $25,000 per year annuity payment that lasts for the rest of his or her life. The person might frame the $500,000 annuity premium as a potential investment loss rather than seeing it for what it is—a conversion of assets into a guaranteed stream of payments that supports consumption during retirement.
The irony with loss aversion is that many annuities actually provide guarantees that hedge against the types of extreme losses that most people have experienced over the past year and a half in the capital markets. I’ll discuss this issue further in future entries.
Last, Professor Fryer discussed the notion of “loss of control” or the fact that the need for control is a natural human tendency. Studies have concluded, for example, that people feel more comfortable sitting near the cockpit when flying because they have a heightened sense of control when they are able to see the pilot. Overconfidence is also a symptom of the need for control. When people are surveyed about activities such as driving or investing, the vast majority are overconfident and consider their skills above average when, by definition, it is not possible for the vast majority of people to be above average.
Again, certain types of annuities involve relinquishing control of a pool for a promise of future income payments, so it’s easy to see how trust and the need for control come into play. That said, there is again a certain amount of irony in that annuity product development—particularly in the form of variable annuities with living benefits—over the past decade or so are able to address the loss of control issues head-on. Again, I will explore this topic in future entries, but suffice it to say that the annuity industry is well equipped from a product standpoint to deal with some of the natural behavioral biases that exist among current and potential annuity customers.
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