Vox Nihili

My line of work involve pensions and I often wonder why most people react so repulsively towards insurance. Even for those who do dabble in them, it is mostly in the form of insuring yourself against bad luck i.e. an accident, theft or your house burning down.

Insuring yourself against “good luck” i.e. longetivity, is almost unthought-of. Under these life insurances, in a nutshell, premiums are paid for the exchange of receiving benefits in the future. These benefits could either come in the form of annuities or assurances (lump sum). The value of the premium is priced such that its present value equals the present value of benefits received.

Let’s focus on the most common of all – life annuities. This is an investment product that pays you an income as long as you live. If death is delayed (benefits are paid for longer than expected), the insurer faces a loss. If death is premature, you lose profit. But you’re dead, so why would you care? Hence, it’s a win-win situation.

Yet there still exist a strong aversion to purchasing annuities. Sure, they’re expensive. Insurers have to be careful not to overestimate mortality (assume people die earlier) to limit a potential loss. If the rate of mortality is too high, the premiums would be insufficient to cover the higher income paid out. Ah, and there is also the risk of having only pilates-practicing vegans swimming in that pool of policyholders. These complexities result in us seeking simpler ways to invest out money. Piggy bank?

The means to seek an alternative investment is rational. But the outright refusal to dabble in annuities is not. Why is this so?

I extract the following from an Economic Review Paper entitled “Why Don’t the People Insure Late Life Consumption?”

“We hypothesize that framing matters for annuitization decisions: in a consumption frame, annuities are viewed as valuable insurance, whereas in an investment frame, the annuity is a risky asset because the payoff depends on an uncertain date of death. Survey evidence is consistent with our hypothesis that framing matters: the vast majority of individuals prefer an annuity over alternative products when presented in a consumption frame, whereas the majority of individuals prefer non-annuitized products when presented in an investment frame.”

To translate the above into layman terms, let me illustrate it using examples from their survey. Using a series of comparisons between fictitious retirees who made different retirement funding decisions, the survey question respondents on who had made the better choice. The results suggest it depends how the question was presented. Analyse the following:

1) Mr. Red can spend $650 each month for as long as he lives in addition to social security. When he dies, there will be no more payments.

2) Mr. Gray can choose an amount to spend each month in addition to social security. How long his money lasts depends on how much he spends. If he spends only $400 per month, he has money for as long as he lives. When he dies, he may leave the remainder to charity. If he spends $650 per month, he has money only until age 85. He can spend down faster or slower than each of these options.

Between these two cases, the former was preferred.

Now look at this:

3) Mr. Red invests $100,000 in an account which earns $650 each month for as long as he lives. He can only withdraw the earnings he receives, not the invested money. When he dies, the earnings will stop and his investment will be worth nothing.

4) Mr. Gray invests $100,000 in an account which earns a 4% interest rate. He can withdraw some or all of the invested money at any time. When he dies, he may leave any remaining money to charity.

No prizes to guessing which is preferred now.

You may have realized that the two Mr. Reds and Mr. Grays are the same but framed in a different manner. Mr. Red had purchased a life annuity, whilst Mr. Gray invested his money in a savings account. Examples (1) and (2) were phrased under the consumption framework, whilst the latter 2 under an investment framework. You can see annuities are preferred when described as sources of spending, but lose its popularity when conveyed otherwise.

Argh. Very lengthy, please bear with me. What did we learn here? Go beyond estimating the rate of return you can get out of an annuity, instead think about what you can spend if you buy one.