While I frequently advocate diversification of retirement income sources as a risk-mitigation strategy in retirement (see for example my post of July 12, 2014), I’m not a big fan of government mandated annuitization of an individual’s retirement assets. I’d like to believe that individuals who have managed their finances during their working careers will be able to continue to do so in retirement without government involvement (see for example my post of August 31, 2014). Understandably, however, not everyone agrees with me. The most recent example of this is a March, 2015 research paper from the Center for Retirement Research at Boston College entitled, “Are Cognitive Constraints a Barrier to Annuitization?”
This research paper presents the results of a study of individuals who were asked to value a $100 change in their monthly Social Security benefit (both the cost they would be willing to pay for an additional $100 and the price they would be willing to receive to give up $100). The study showed that the respondents had difficulty in valuing this change and the magnitude of their difficulty was correlated to the respondent’s cognitive ability. Even though buying or selling Social Security benefits is not possible, the researchers use the results of this hypothetical exercise to conclude that “policymakers need to be aware that many individuals, on their own, are unable to make good decisions about managing money in retirement”, thereby supporting “US policymakers [who] have expressed interest in encouraging annuitization of balances in 401(k) plans...”
The study does not provide sufficient details to verify how the benchmark value of a $100 change in Social Security benefit of $16,855 was determined. The paper indicates that this value was determined using “mortality and interest rate assumptions from the Social Security Administration’s Trustees,” but it does not provide the age or sex of the hypothetical recipient(s). If we are talking about a 65 year old male with approximately a 23 year life expectancy (based on the SoA 2012 Individual Mortality Table and a 1% per year mortality improvement) and the current recommended assumptions for the Excluding Social Security spreadsheet provided in this website, we are looking at a value in excess of $22,000. The current CORI Retirement Index value for an inflation indexed $100 per month lifetime annuity for a 65 year old is in excess of $25,000.
In any event, it looks like most of the study’s participants (and perhaps even the study’s authors) undervalued a $100 change in the Social Security benefit in comparison to the value based on current annuity pricing models. For numerous reasons (the “annuity puzzle”) that seem to baffle academics, economists and researchers, many individuals don’t value annuities as highly as the life insurance companies that sell them. This fact doesn’t by itself mean that these individuals “may not be making rational well informed decisions.” Besides, from a policy perspective, if many individuals place less value on annuities than their actuarial cost, how much sense does it make to force them to buy something at that higher cost that they don’t necessarily want?
On the other hand, I have no problem if the government’s (Department of Labor’s) role in “encouraging annuitization” is limited to providing useful information to educate individuals on the potential benefits of annuitization of defined contribution balances or on the considerations in selecting annuities vs. lump sums in defined benefit plans (see my post of February 18, 2015 for examples of information that might be helpful for the latter). I’m all in favor of making more educational material available to retirees of all cognitive ability levels.
