Analysis Suggests Participants Don’t Understand Value of Annuities

PLANSPONSOR.com

December 28, 2009 (PLANSPONSOR.com) – An analysis of retiring participants from one public pension plan suggests they do not understand the value of life annuity payments.

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… [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 … underestimate the value of the incremental life annuity payments," the researchers wrote. …
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. …

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 http://www.nber.org/.
Rebecca Moore
editors@plansponsor.com