a partial solution to the annuity puzzle
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1 59 Disengagement: a partial solution to the annuity puzzle Hazel Bateman Director, Risk and Actuarial Studies, University of New South Wales, Sydney Christine Eckhert Marketing and CenSoC, University of Technology, Sydney John Geweke Economics and CenCoC, University of Technology, Sydney Fedor Iskhakov CEPAR, University of New South Wales, Sydney Jordan Louviere CenSoC, University of Technology, Sydney Stephen Satchell University of Cambridge, UK Susan Thorp Finance, University Technology, Sydney Most members of defined benefit (DB) pension plans enjoy a natural continuity between pre- and post-retirement income generation via pre-set annuity payments. By contrast, members of defined contribution (DC) retirement saving plans, such as under Australia s superannuation system or for 401(k) plans in the US, who want to insure against outliving their income must forfeit lump sum savings in exchange for a lifetime income stream while also managing the need for liquid funds to cover uninsured contingencies, such as large health expenses. Despite strong theoretical support for the value of lifetime annuity purchase, the weak global demand for voluntary life annuities remains an enduring puzzle (Brown 2008; Mitchell, Piggott and Takayama 2011; and Benartzi, Previtero and Thaler 2012). In the US and Australia, both of which operate private retirement savings plans, the conversion of retirement accumulations to lifetime annuities is very low. In the US only around 1 per cent of 401(k) plan retirees offered a life annuity actually purchase one while in Australia in 2012 less than 200 life annuity policies were sold at retirement in a market with several million retirees. The negligible demand for life annuities is more surprising in Australia where virtually all workers are covered by a 9 per cent mandatory employer contribution into an individual DC account supplemented by tax preferred voluntary employer and employee contributions. Despite mandatory participation and a minimum contribution rate, Australian retirees can elect to take their superannuation benefits as one, or of a lump sum, a retirement income stream or a combination of both. Retirement income products currently available in the Australian market include account-based pensions (a form of phased withdrawal product), and immediate annuities (including both term and life annuities). Hybrid products have been offered from time to time, but the market is slight due to regulatory restrictions. Currently around 50 per cent of retirement accumulations (by assets) are taken as lump sums (down from around 80 per cent a decade ago) and around 50 per cent of retirement assets are converted to income streams (Bateman and Piggott 2011). Of the conversions to income streams, by far the most popular have been phased withdrawal/ account-based pension products accounting for 98 per cent of the retirement income stream market in Term annuities accounted for just 2 per cent of total income streams purchased (by assets); while the take-up of life annuities was negligible with only less than 200 policies sold in 2012 (see figure 1). In the light of this evidence, it is natural to assume that the unpopularity of lifetime annuities is a reflection of consumer preferences. Moreover, most research into annuity purchase decisions whether theoretical, empirical or behavioural, assumes that ordinary people know what retirement benefit products are available and understand how they work. However, results of a preliminary survey we conducted (prior to designing and implementing this benefits choice study) showed scant product awareness and minimal understanding of the main features of the income streams available in Australia. For example, only one third of the 920 middle-aged respondents had heard of a life annuity, with only 20 per cent and 8 per cent understanding its longevity and income guarantee characteristics. Respondents showed similar low awareness for account-based pensions (Bateman et al. 2013). A lack of understanding of retirement benefit products by ordinary people is not surprising. These are complex, once-in-a-lifetime products, unfamiliar to most pre-retirees and especially confusing to people with low financial literacy (Brown et al. 2013). The recent switch to DC plans (and the Australian practice, until recently, of taking lump sums) means that there has been limited opportunity for social learning. Unlike other major financial decisions, such as home purchase, older generations have little experience with privately provided retirement benefit products and cannot offer advice. Furthermore, the retirement benefit
2 60 Figure 1: Value of private retirement income streams in Australia ($A million) 35,000 30,000 25,000 20,000 15,000 10,000 5, Term annuity Lifetime annuity Account based pension Term allocated pension Source: Plan for life (2012) decision is high stakes (often relating to the household s largest non-housing asset), is typically made only once and is often irreversible, which precludes learning from experience. The experimental survey To explore these issues further we conducted a choice experiment to investigate the impact of plan member awareness and specific product understanding on the quality of retirement benefit choices, and particularly, the demand for annuities. We selected a random sample of 854 respondents from those members of the Pureprofile panel of 600,000 Australians who had at least one superannuation (retirement saving) account, were between the ages of 50 and 64 and who satisfied the residency requirements of the public Age Pension. Under Australia s Superannuation Guarantee, almost all workers between 18 and 65 years of age participate in the mandatory retirement savings system, mostly as members of DC, privately managed, funds. Accumulations are preserved until at least age 55 (rising to age 60 for those born after 30 June 1964) at which time plan members must decide how to use them. In reality retirees have freedom of choice between a lump sum and a short menu of retirement income streams (as described above). Retirees who purchase income stream products accrue tax concessions over those who take lump sum payments, and approximately half of retirement accumulations are converted into income streams (almost all non-annuitized phased withdrawal products). It follows that the choice task is a simplified, hypothetical version of a decision that respondents will have to make in the near future. The respondents completed a four-part survey with an embedded experimental task. The first part of the survey collected data on standard demographics (which was also used to separate the respondents into treatment groups by gender, wealth and planned retirement age). The second part of the survey was the retirement benefits choice task, in which the pre-retirees were asked to choose the percentage of financial wealth at retirement to allocate to two retirement income streams in two settings. In the first setting, the choice was between a life annuity and a liquid phased withdrawal account invested in risky assets (ie, an investment account). In the second setting, the choice was between a life annuity with a 15-year guarantee and the investment account. On the basis of the results from our preliminary survey, we did not assume that respondents were aware of or understood the products in the choice experiment. On the contrary, we gave the products generic names - Product A (Get a guaranteed income), Product B (Withdraw a regular income) and Product C
3 Disengagement: a partial solution to the annuity puzzle 61 (Get a guaranteed income with a fixed term payment period) and offered respondents a simple explanation and comparison of the three products as answers to five questions, as summarised in table 1. Following completion of the retirement benefits choice task, respondents answered questions that tested their recall of the key features of the retirement benefit products (which we call the recall quiz ). In the third part of the survey, respondents answered questions on retirement planning and expectations, on intentions to make bequests and/or undertake precautionary savings and on plans to liquidate housing wealth, as well as questions to measure mortality expectations and quality of life. The final part of the survey consisted of questions measuring numeracy and financial literacy skills (Lipkus 2001, Lusardi and Mitchell 2011) self-assessed knowledge of finance, use of financial advisors and awareness and knowledge of the superannuation/retirement saving system and existing retirement income products (Agnew et al. 2012). The retirement benefits choice task Under the retirement benefits task, respondents made pair-wise allocations of their (hypothetical) retirement accumulation in the two settings that is, investment account versus life annuity and investment account versus life annuity with 15-year guarantee - at four risk levels. The risk they confronted was the chance of running out of funds in the investment account before the end of life, and consequently having to live on a reduced retirement income. By contrast, the life annuity offered a guaranteed income stream for life but no option to make a bequest or drawdown from underlying assets. Table 1: Description of retirement income products Who provides this product? How much income will I receive? How long do payments last? What happens if I die? Can I withdraw a lump sum for unforseen events of changes of plans? The choice task allowed respondents to choose from a continuum of allocations to each product from 0 per cent to 100 per cent in increments of 5 percentage points rather than forcing them to choose between a 100 per cent allocation to either product (see figure 2). As survey respondents moved a slider along a product configurator, the information they saw about the guaranteed part of expected annual income and share of wealth you can withdraw as a lump sum changed for each allocation. Using this information respondents were asked to choose their preferred combination of the two products. For each pairing of retirement benefit products, the experiment varied the risk of exhausting income from the investment account before the end of life, from very low (one in ten), through low (one in four), to moderate (two in four) to very high (three in four). As a result, we obtained two sequences of wealth allocations revealing respondents changing preferences for benefit products providing guaranteed or variable retirement income (with access to capital) as risk increases. Choices from this task let us evaluate whether the sequence of retirement wealth allocations each respondent made were consistent with behaviour we would expect from risk-aware individuals. That is, we could identify whether individuals chose no less of the life annuity (Product A) or life annuity with guarantee (Product C) when the chance of exhausting all the money in their investment account (Product B) rose through the four risk levels. This condition tested whether respondents understood the main insurance feature of the life annuity (with or without the 15-year guarantee). Results and discussion The survey and embedded benefit choice task provided information on: preferences for alternative retirement benefit products from a representative sample of pre-retirees who should be considering these decisions. the ability of these survey respondents to make sensible allocations of retirement wealth (where they took account of a varying risk of running out of money due to market and longevity risk).
4 62 Figure 2: Value of private retirement income streams in Australia ($A million) Please use the slide to allocate your wealth to Product A and Product B Product A 75% 100% in A 100% in B 1. Your expected annual income: 2. Guaranteed part of your expected annual income: $26,730 $24,790 of $26,730 Product B 25% 3. Share of wealth you can withdraw as a cash lump sum: 25% (You can only withdraw from Product B) The chance your income from Product B will run out during retirement, that is, your chance of receiving ONLY the guaranteed part of income is: LOW (1 in 4) Source: Bateman et al. (2013) It also collected responses to a comprehensive set of relevant questions on demographics, knowledge, attitudes and expectations. Our findings can be summarised as follows. Respondent choices indicated substantial interest in life annuity products (both with and without a guarantee feature) in an experimental context, suggesting that interest is provoked when people are made aware of the retirement benefit products and their key insurance features. A large minority of the respondents made choices which were consistent with those expected of risk aware individuals. That is, they chose no less of the life annuity when the chance of exhausting all the money in their investment account rose. Measures of financial capability, such as numeracy, financial literacy, and pension/ superannuation system and product knowledge increased task engagement (measured using the post task recall quiz that tested respondent s knowledge of the five common features of the retirement products described in the allocation experiment). Engagement with the task at hand was also higher for those who reported advanced retirement financial planning, optimistic subjective survival expectations expectancy, an intention to retire before state pension age and for females. However, only numeracy skills and our measure of engagement with the task at hand (ie, the recall quiz ) increased the probability that respondents made sensible retirement benefit choices that is, increased their allocation to the life annuity products as the risk of exhausting the funds in their investment account increased. In other words, financial literacy is only indirectly connected with sensible choices. This suggests that the key to making good retirement benefit decisions is an understanding of the information specific to the decision at hand. Concluding comments Our findings have important implications for policy makers and providers of retirement income products. While revealed preference data suggests that individuals show scant interest in life annuities and other longevity products (which probably motivate inaction by government and industry), our hypothetical benefit allocation task indicates the opposite when products are described in terms of their features, rather than by their commercial names. Second, our study provides a test of the role of financial competence (numeracy and financial literacy) and commercial product knowledge on the ability of people to understand and interpret product characteristics information. That those with better skills are more engaged and that the more engaged make better decisions suggests that resources could be productively directed towards improving the financial skills and product and system knowledge of real world retirement savers.
5 Disengagement: a partial solution to the annuity puzzle 63 Sources Agnew, JR; Bateman, H; and Thorp S (2012), Financial Literacy and Retirement Planning in Australia, Australian School of Business Working Paper ACTL Available at < J.R.%20Agnew,%20H.%20Bateman%20and%20S.%20 Thorp%20-%20Financial%20Literacy%20and%20 Retirement%20Planning%20in%20Australian.pdf> Bateman, H and Piggott J(2011), Too Much Risk to Insure? The Australian (non-) Market for Annuities, in OS Mitchell, J Piggott, N Takayama (eds), Securing Lifelong Retirement Income: Global Annuity Markets and Policy, Oxford University Press: Bateman, H; Eckert, C; Geweke, J; Iskhakov, F; Louviere, J; Satchell, S and Thorp, S (2013), Disengagement: A partial solution to the annuity puzzle, CenSoC Working Paper No , University of Technology, Sydney. Available at < Benartzi, S; Previtero A; and Thaler R (2012), Annuitization Puzzles, Journal of Economic Perspectives, 25(4): Brown, JR (2008), Understanding the Role of Annuities in Retirement Planning, in Lusardi, A (ed), Overcoming the Savings Slump, University of Chicago Press, Chicago: Brown, JR, Kapetyn, A; Luttmer, EFP and Mitchell, OS (2013), Complexity as a Barrier to Annuitization: Do Consumers Know How to Value Annuities?, Pension Research Council Working Paper, WP , Pension Research Council, University of Pennsylvania. Available at < document.php?file=1040> Lipkus, IM; Samsa, G and BK Rimmer (2001), General Performance on a Numeracy Scale among Highly Educated Samples, Medical Decision Making, 21(1): Lusardi, A and Mitchell, OS (2011), Financial Literacy around the World: An Overview, Journal of Pension Economics and Finance, 10(4): Mitchell, OS; Piggott, J and Takayama, N (2011), Securing Lifelong Retirement Income: Global Annuity Markets and Policy, Oxford University Press. Plan for Life (2012), The Pension and Annuity Market Research Report, Plan for Life Actuaries and Researchers, Mt Waverly, Victoria.
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