Rational Choice with Complex Products: Consumer Valuation of Annuities

Abstract

Because life annuities provide significant theoretical benefits to retirees, the lack of demand for life annuities is a puzzle that is not well understood. It has been hypothesized that some combination of ambiguity aversion, the desire to leave inheritances, and liquidity needs reduce annuity demand. However, a life annuity is a complex financial product unfamiliar to many consumers. The inability to assess the value of a life annuity with any reasonable degree of accuracy requires numeracy skills and financial knowledge that may be beyond the reach of an average individual investor. Using data from the 2008 Health and Retirement Study, we investigated the value respondents placed on a hypothetical $500 monthly life annuity payment at age 65. In addition to testing factors theoretically related to annuity valuation when investors have full information, this study models the impact of financial sophistication on the ability to reasonably estimate the value of a hypothetical life annuity. We find that the majority of respondents are not able to come close to a reasonable estimate of annuity value - even those who are more financially sophisticated. The strongest predictor of annuity valuation is self-assessed myopic preferences. These result provide evidence that the importance of an annuity as a commitment device may be underestimated.

Keywords: annuities, financial literacy, household finance, retirement policy

JEL Classification: D12, D18, H55