Annuities are an investment people think of when the chips are down, according to research from a business professor at the Richard Ivey School of Business.
Alessandro Previtero, an expert in behavioural finance and financial decision making, examined annuities versus lump-sum payments, widely considered the two most popular types of retirement plans. Over a six-year period from 2002 to 2008, he surveyed 100,000 retirees with defined-benefit pension plans.
He found that whether retirees chose lump-sum payments or annuities was tied to how well the stock markets was performing.
If markets had been in the tank during the previous 12 months, then more retirees opted for the annuity. But if markets had soared during that same time period, then more retirees preferred lump-sum payments.
Prof. Previtero describes this behaviour as "myopic extrapolation."
"People have a strong tendency to think that what has happened will continue to happen," he says. "I call it myopic because people only look at very short-term trends."
With an annuity, people invest a large sum of money and in return get a guaranteed steady, regular income for the rest of their life. While the concept of an annuity seems simple, there are many complex issues to consider such as whether you want fixed or variable payments, which are based on market performance, or if you want a single or joint annuity, which pays a monthly sum to a couple until both die. One downfall is that some annuities don't leave anything to an investor's heirs. Those investors who do buy annuities often want to defer taxes, since the income is taxed when it's paid out. They likely don't have a pension and want the security of a steady monthly income for the rest of their life
Prof. Previtero says that retirement planning used to be easier. That's because people tended to spend most of their career working for the same company, many of which had defined-benefit pension plans that paid people a set amount of money each month of their retirement until they died.
But defined-benefit pension plans are now being replaced by defined-contribution pension plans, where the amount you get each month depends on how well the plan has performed in the markets.
That has made retirement more complicated. "People now have difficult decisions to make - when to retire, how to invest their money, and how much to spend on retirement so their money doesn't run out," Prof. Previtero says.
He believes that the biggest retirement risk is the "longevity risk." For example for every 10 men who reach the age of 65, one will die at 70 while the will live to 92. The one who dies at 70 has only five years of consumption to finance, but the one who dies at 92 has to finance 27 years of retirement. That's a huge difference.
An annuity is one way to deal with the longevity risk, Prof. Previtero says, but few people choose to invest in annuities and financial products tied to them don't sell well.
Prof. Previtero also looked into the behavioural reasons for that. Retirees were given a check box option by their organization to say whether they wanted a lump-sum payment or an annuity. With this simple choice, about half the retirees opted for the annuity.
But when retirees were not given the check box option as part of their retirement plan, research showed that few people take their cash and purchase an annuity from an insurance company on their own. The main reason for this is inertia, he says.
Checking a box for an annuity on a company form is very different from going out and buying one yourself. "Buying an annuity from an insurance company is a complicated process," he says. "You must choose an insurance company, talk to a financial adviser, decide upon what annuity product you want, and then write a cheque and give up a large sum of money. For most people, these are huge obstacles."