Assumption Based Anomalies
Emotions Based Anomalies
In the near future, private retirement savings will become more important than ever, caused by the upcoming retirement of the baby boomer generation plus increasing life expectations. This raises the question of how to convert accumulated wealth into a secure retirement income. How people choose among the saving alternatives will determine who are the beneficiaries from these large cash flows (Hu and Scott, 2007). In this respect life annuities are a quite valuable option; whereby an individual pays a large lump sum in advance and receives in return a regular payment stream and eliminate the risk of longevity (for further detail see: Cannon and Tonks, 2008).
However, the annuity market faces a considerable lack of demand and many researchers attempted to solve this annuity puzzle through relaxing the assumptions. The origins; Yaari (1965) proposed the full annuitisation of the ‘homo-economicus’, the rational utility maximize, in his retirement based on the assumptions of fair actuarial pricing and no bequest motive. As the homo-economicus is expected to make adequate option evaluations and informed decisions the actual investor suffers under bounded rationality and receives not perfect outcomes (Mitchell & Utkus, 2003). Recent studies in the annuity sector moved away from how someone ‘should’ behave to how investors ‘actually’ behave based on theories from financial behaviour. This paper attempts to explain many misty puzzle parts and gives valuable insides of the low annuitisation rate. The first part is a recap of the annuity market under relaxed assumptions. The next part describes several financial behaviour anomalies and their impact on annuitisation.
Assumption Based Anomalies
By relaxing the assumptions, to reflect consumer behaviour adequate, annuitisation remains positive but not full annuitisation as proposed by Yaari (Davidoff et al., 2005 and Rusconi, 2008).
The anticipated imperfection in the annuity market with too high prices (Brown, 2007; Finkelstein & Poterba, 2004; Friedman & Warshawsky, 1990 and Mitchell et al., 1999) cannot solely explain the low demand. Nevertheless, Rusconi (2008) assumes fair pricing among better established insurances and Friedman and Warshawsky (1990) justify the overpricing through adverse selection as individuals have more information about longer life expectations than insurers who use averages. Departing from the model the bequest motive seems to be one of the major reasons why investors shun annuities (Bernheim, 1991; Friedman & Warshawsky, 1990; Hu & Scott, 2007; McMinn, 2009 and Rusconi, 2008). Conversely, bequest appears not sufficient as explanation since retirees could partial their wealth for themselves and for their heirs (Brown, 2007). An additional explanation for the low private annuitisation is pre-existing annuitisation through the social security system or pension plans (Bernheim, 1991; Brown & Poterba, 2000; Mitchell et al. 1999 and Rusconi, 2008). Furthermore, Brown (2007) argues that retirees at the lower end of the wealth distribution do not want to annuitise their small savings and rely heavily on the social system, whereby the demand by wealthier retirees differs. In the literature is also argued that couples can insure themselves by by fund pooling and mortality risk sharing which leads to a lower utility gain from annuities for them (Kotlikoff & Spivak, 1981 and Brown & Poterba, 2000). However, after death of the partner the annuity option seems to be more attractive for the individual. Moreover, many retirees require financial flexibility for uncertain medical expenditures; which makes full annuitisation less attractive (Gardner & Wadsworth, 2004 and Turra & Mitchell, 2004). Brown (2007) suggests as alternative a combined annuity with health insurance and Milevsky and Young (2002) propose a gradual annuitisation at older ages but even these alternatives are rather less observed.
Emotions Based Anomalies
Taking the changes by relaxing the assumptions into account, they cannot explain completely the annuitisation puzzle (Brown, 2007); hence further digging into investor behaviour and irrational decision making is required.
Financial behaviour reasoning is given by Kahneman and Tversky (1979) via ‘ cumulative prospect theory’ and by Hu and Scott (2007) as ‘ mental accounting’; the subjective risk perception based on experience and not on probabilities. Investors face the low risk of dying earlier which is subjective overestimated and the effect is a gamble perspective about annuities, based on the question: ‘Will I live long enough to get my initial payment back?’ (Society of Actuaries, 2004). The outcome is a much low annuitisation rate (Cannon & Tonks, 2008) and confirms Kahneman and Tversky (1979) diagnosis that investors are rather loss averse than risk averse. Consequently, the most popular annuities are the guarantee of a minimum number of payouts regardless of death (Hu & Scott, 2007). This combination equals a series of zero coupon bonds for the first period and a longevity annuity afterwards. The irony in this case is that investors buy the combination but not the individual parts based on their mental accounting and the loss perception of not getting their investment back (Scott et al., 2006). Mental accounting can be divided into ‘ heuristic availability’; events which are more easily imagined and available to the mind bear a greater subjective probability (Hu and Scott, 2007) and ‘conjunction fallacy’ (Tversky & Kahneman, 1983), where a combination of events deems to have a higher likelihood than an individual event. This means concrete for annuities that an individual can easily imagine dying in many different ways (e.g. through a car accident or heart diseases) and overemphasises the probability of an early death. Moreover, the fear of illiquidity might be exaggerated by the heuristic availability and conjunction fallacy.
- Quote paper
- Karime Mimoun (Author), 2010, Elucidation of Annuitisation Anomalies via Financial Behaviour, Munich, GRIN Verlag, https://www.grin.com/document/151591