Saturday, 11 June 2011

Thaler, annuities, freedom and self-knowledge

Richard Thaler has an oddly limited writeup of the "annuity puzzle" in the New York Times this week. He presents a choice between two people retiring at 65. One gets a guaranteed $4,000/month for the rest of their life (a standard annuity). The other retains a standard investment portfolio and draws down $4,000/month until it runs out (at the age of 85, if he lives that long) - or $3,000/month till he's 100.

Presenting only these three options, he argues that people should really opt for the annuity as it is lower-risk and saves your family the worry of having to support you after the money runs out. The puzzle, in Thaler's view, is that most people don't buy the annuity but instead keep their money in an investment portfolio that they manage themselves.

But I'm not sure this is all that puzzling. In reality, someone who keeps their money in a portfolio is not likely to draw on it at a consistent $4,000/month rate. Why would they happen to withdraw exactly the same monthly income as they would happen to get if they bought an annuity? Anyone who has managed to save this much (about $600-700,000) has many more options.

You might take a lump sum of $20,000 for a cruise, $40,000 for your dream car or $200,000 for a holiday cottage; or you may prefer to make a contribution to your grandchildren's education. Conversely, you might live more frugally some of the time, getting by on $2,000/month when you can, and spend more at Christmas or in the summer.

You could have all sorts of reasons for this. Your needs may change from month to month; you might have been waiting years for the chance to have that car or cruise and want to enjoy it while you can. You might have specific concerns about the future. You might (as Thaler mentions) want to leave some money in your inheritance in case you die before 85. But one powerful rationale could be that you just want to see how it goes - you won't know how much you will want to spend each month until you have figured out your new lifestyle.

Thaler ascribes most of the behaviour to risk aversion and how the annuity choice is framed (and whether it's a default). But the "see how it goes" effect must be a major factor. This particular form of bias (if it is a bias) results from a lack of knowledge of our own preferences, and as such is not accounted for by either rational choice models, nor most behavioural explanations. But I believe it's much more fundamental to the behavioural economy than defaults, risk framing or some of the other Nudge party tricks.


Lord said...

One would have to ask what it is worth for the insurer to accept that risk and whether that may be too high a price to pay. People may underestimate the risk they face, or they may conclude that the risk they face can also be offset by the control they have over their funds. They may be able to lower their risk by their own management or face both lower returns and lower expenses mitigating it. An annuity is a large one time bet. It may be lower risk over time but carries a lot up front.

PunditusMaximus said...

This is kind of silly -- part of the overall picture is that we've already purchased the annuity in the form of Social Security. Why would we assume that a corner solution is best? I'd think that I'd want a baseline income, combined with some of the freedom/risk that savings would grant me.

Why can't I get half and half? I know I'm going to spend $2k in a given month, but it might not be much more in low-key months. In the meantime, I've got a nice nest egg for vacations and emergencies.