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