Analysis Suggests Participants Don't Understand Value of Annuities

John Chalmers from the Lundquist College of Business, University of Oregon, and Jonathan Reuter from the Carroll School of Management, Boston College, analyzed data on Oregon Public Employees Retirement System (PERS) retirees who must choose between receiving all of their retirement benefits as life annuity payments or receiving lower life annuity payments coupled with a partial lump sum payout, and found that for the median retiree, the expected present value of the incremental life annuity payments is 1.50 times the lump sum payout, and demand for lump sums is low – consistent with rational models of retiree behavior. However, looking at variation in the value of the incremental life annuity payments arising from how PERS calculates retirement benefits, the researchers found evidence that demand for lump sum payouts is higher when the forgone life annuity payments are more valuable. 

Chalmers and Reuter also found that demand for lump sum payouts is higher when the lump sum payout is “large,” and when equity market returns over the prior 12 months are higher.

“Collectively, these findings suggest that retirees value incremental life annuity payments at less than their expected present value, either because they do not know how to accurately value life annuities or because they have strong demand for large lump sum payouts,” the researchers wrote in a working paper for the National Bureau of Economic Research (NBER).

The researchers did find that those with poor health at retirement more consistently utilized “value-maximizing decision-making.”

According to the NBER working paper, the Oregon PERS data showed that the higher the money’s worth of the incremental life annuity payments, the more likely the retiree is to choose the partial lump sum option over the full life annuity option. “This (robust) finding suggests that retirees facing more valuable incremental life annuity payments either attach greater value to the lump sum payout or are more likely to underestimate the value of the incremental life annuity payments,” the researchers wrote.

Chalmers and Reuter said that generally, they found evidence that retirees attach less value to incremental life annuity payments than expected present value calculations suggest they should. Specifically, they found that retirees are more likely to choose the partial lump sum option when the partial lump sum payment is “large” (in the top decile of lump sum payments offered to PERS retirees, measured in December 2003 dollars) or the incremental life annuity payment is “small” (in the bottom decile of incremental life annuity payments offered to PERS retirees, measured in December 2003 dollars), patterns the researchers said are consistent with retirees relying on less sophisticated valuation measures than money’s worth.

In addition, the researchers found that demand for the partial lump sum option is increasing in recent stock market returns – even after we control for returns earned in the PERS retirement account – suggesting that retirees use the wrong discount rate to value life annuity payments, perhaps because they want to chase recent equity market returns, the paper said.

The research findings suggest that the fraction of retirees demanding a lump sum is associated with the returns on the prior 12-month returns to the S&P 500 index. “In other words, while the low demand for lump sum payouts may reflect a general understanding that PERS life annuity payments are unusually valuable, the retirees who we study have an imperfect understanding of how to measure this value,” the researchers wrote.

They noted the “interesting exception” that retirees who die within 48 months of retirement are more likely to choose the partial lump sum payout, “just as life-cycle models and existing evidence on adverse selection would predict.” Chalmers and Reuter speculate that a retiree’s ill health makes the variation in the value of life annuity payments easy to observe and interpret.

The researchers also found that demand for the partial lump sum option is lower for retirees earning high salaries, and speculate that this is because these retirees are less financially constrained or more financially literate.

To order a copy of HOW DO RETIREES VALUE LIFE ANNUITIES? EVIDENCE FROM PUBLIC EMPLOYEES, go to www.nber.org.