Angst Over Annuities

Giving up a lump sum in favor of a series of payments may wreak havoc with our mental accounts.

How about this sweet deal: You collect regular income in retirement provided by strangers who don’t need the money. Plus, the income lasts as long as you do, so you eliminate the risk of running out of funds.

That describes an annuity, something everyone should consider as part of a retirement plan, but relatively few people do. Specifically, we're talking about an immediate fixed annuity, which lets you invest a lump sum that immediately begins paying you income until you die.

Annuities have other benefits. They pay a fixed amount, a plus when it comes to budgeting. And evidence shows that insurers that market annuities haven’t kept up with rising life expectancies, so they sell products that benefit buyers more than they intend, according to Shlomo Benartzi, a professor at the University of California, Los Angeles, and chief behavioral economist at the Allianz Global Investors Center for Behavioral Finance.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%
https://cdn.mos.cms.futurecdn.net/hwgJ7osrMtUWhk5koeVme7-200-80.png

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

In "Annuitization Puzzles," a white paper released by the center that's soon to be published in the Journal of Economic Perspectives, Benartzi and colleagues Alessandro Previtero, of the University of Western Ontario, and Richard Thaler, of the University of Chicago, tackle the reasons people have a mental block when it comes to buying annuities.

Of course, annuities aren't for everyone. You need savings for health and other emergencies, and if your nest egg is small, you shouldn't spend some of it on an annuity. Also, many people prefer to keep money for their heirs.

But given the benefits of annuities, those factors don't fully explain why they're not more popular. Benartzi and his colleagues say that one reason we're reluctant to write a big check for an annuity is the phenomenon known as loss aversion. That is, we feel twice as much pain from a financial loss than we feel pleasure from an equivalent gain. If you think you might "lose" the money spent on an annuity by dying too soon, loss aversion kicks in.

Also, there's mental accounting. With mental accounting, we separate our assets into pots based on what we think they’re intended for -- such as money to pay debts versus money for savings. Switching from a company retirement plan to an individual retirement account to an annuity involves the stress of leaping among several accounts. Plus, giving up a lump sum for small payments may wreak havoc with our mental accounts.

Easy access. Then there's simple inertia. When automatic features make it easier for people to invest in retirement savings plans and increase the amount they contribute, they're more likely to save, and to save more. Likewise, studies have shown that when employees are given easy access to annuities in their retirement plans, they tend to choose them overwhelmingly. But such access to annuities is still rare, and Benartzi and company recommend that more plans consider offering them.

Their white paper also notes that potential buyers may be put off by the cost of annuities. In fact, when Kiplinger's recently surveyed its readers, 55% of respondents said they wouldn't buy annuities because of "fees and expenses." That was far more than the 15% who thought annuities wouldn't "pay off" based on cost and life expectancy.

We've been critical of certain types of deferred annuities, and certain annuity providers, for fees and expenses that are clearly rip-offs. So we take responsibility for promoting a justifiable wariness. But we also think that immediate annuities can be a good way to provide a stream of retirement income (see our take on some deferred annuities).

To help overcome your mental blocks, start thinking about how an immediate annuity might fit into your retirement plan years before retiring. That will give you time to think logically about the pros and cons and help you avoid making a snap decision at a time when your life is in transition.

Bob Frick
Senior Editor, Kiplinger's Personal Finance