Cognitive Constraints on Valuing Annuities

42 Pages Posted: 29 Jun 2013 Last revised: 18 May 2023

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)

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Date Written: June 2013

Abstract

We show that people have difficulty valuing annuities, and this, instead of a preference for lumpsums, helps explain observed low annuity demand. Although the median price at which people are willing to sell an annuity stream is close to the actuarial value, many responses diverge greatly from optimizing behavior. Moreover, people will pay substantially less to buy than to sell annuities. We conclude that boundedly rational consumers adopt "buy low, sell high" heuristics when confronting a complex trade-off. This suggests that many consumers do not make optimizing decisions, underscoring the difficulty of explaining cross-sectional annuity valuation differences using standard models.

Suggested Citation

Brown, Jeffrey R. and Kapteyn, Arie and Luttmer, Erzo F.P. and Mitchell, Olivia S., Cognitive Constraints on Valuing Annuities (June 2013). NBER Working Paper No. w19168, Available at SSRN: https://ssrn.com/abstract=2287028

Jeffrey R. Brown (Contact Author)

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Arie Kapteyn

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IZA Institute of Labor Economics

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Erzo F.P. Luttmer

Dartmouth College ( email )

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IZA Institute of Labor Economics

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Olivia S. Mitchell

University of Pennsylvania - The Wharton School ( email )

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