The Pension Research Council
Working Paper

Complexity as a Barrier to Annuitization: Do Consumers Know How to Value Annuities?

Jeffrey R. Brown, Arie Kapteyn, Erzo F. P. Luttmer, and Olivia S. Mitchell

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Abstract — This paper provides experimental evidence that individuals have difficulty valuing annuities, and this difficulty - rather than a preference for lump sums - can help explain observed low levels of annuity purchases. Although the median price at which people are willing to sell an annuity is close to median actuarial values, this masks notable heterogeneity in responses, including substantial numbers of respondents whose responses are difficult to reconcile with optimizing behavior under any reasonable parameter assumptions. We also discover that people are willing to pay substantially less to buy a larger annuity, a result not due to liquidity constraints or endowment effects. Strikingly, we also learn that individual responses to the buy versus sell decisions are negatively correlated, an effect that is stronger for the less financially sophisticated. Our findings are consistent with boundedly rational consumers who adopt a "buy low, sell high" heuristic when faced with a complex trade-off. Moreover, at the margin, subjective valuations vary nearly one-for-one with actuarial values but are uncorrelated with utility-based measures designed to measure the insurance value of annuities. This supports the hypothesis that people use simplifying heuristics to think about annuities, rather than engaging in optimizing behavior. Results also underscore the difficulty of explaining the cross-sectional variation in annuity valuations using standard empirical models. Our findings raise doubt about whether most consumers can make optimal decisions about annuitization.