Time Inconsistent Preferences and the Annuitization Decision

Abstract

Good news can involve difficult decisions. For example winning a lottery jackpot can go along with the decision, whether to have the jackpot paid out immediately as a lump sum or as periodic annual payments. Also when entering retirement most people face the decision whether they want their defined contribution account balance paid as a lump sum or to annuitize that amount. The fact that people tend to choose the lump sum even if economic reasons suggest that they should choose the annuity is called the annuity paradox. In a large online survey we find that people behave time inconsistent: older people have a stronger tendency to choose the lump sum than younger people when they are asked to predict today what to choose when they retire. This effect is considerably stronger for participants that answer simple time preference questions inconsistently. Our findings suggest to think about precommitment devices for the annuitization decision.

What Do We Know About Annuitization Decisions?

“…Starting with age , most theoretical and empirical studies find that being older increases the attractiveness and chances of holding annuities or their attractiveness to individuals, except when taking into account tax regimes with higher taxes for higher ages (Kling et al., ), for instance. In addition, in an empirical study of annuitization decisions in the context of the IBM DB retirement plan, Previtero () finds a negative correlation between age and annuitization rates, similar to Schreiber and Weber's () findings based on a survey, who explain their observation with reference to hyperbolic discounting of future payments.…”

“…(). Schreiber and Weber () further find that hyperbolic discounting can help to explain a low annuity uptake by those who are close to retirement.…”

Welfare implications of product choice regulation during the payout phase of funded pensions

“…Benartzi et al (2011), for example, point out that the same behavioural factors that explain saving behaviour, such as self-control problems, inertia, and lack of financial sophistication, help to understand how individuals approach the task of asset decumulation. Further behavioural explanations for the reluctance to annuitise include choice bracketing (Read et al, 1999), the persistence of default options during the payout phase (Bu¨tler and Teppa, 2007), the complexity of the annuitisation decision (Brown et al, 2011), and time-inconsistent preferences (Schreiber and Weber, 2013). Further behavioural explanations for the reluctance to annuitise include choice bracketing (Read et al, 1999), the persistence of default options during the payout phase (Bu¨tler and Teppa, 2007), the complexity of the annuitisation decision (Brown et al, 2011), and time-inconsistent preferences (Schreiber and Weber, 2013).…”

The Effect on Annuities Preference of Prompts to Consider Life Expectancy: Evidence from a UK Quota Sample

“…; Goldstein et al . ; Salisbury and Nenkov ; Schreiber and Weber ). We ask a quota sample of Britons to choose between taking their pension in cash and taking it as an annuity that pays a guaranteed income each year for the rest of the recipient's life.…”

“…). Second, present‐bias reduces annuities preference (Brown and Previtero ; Schreiber and Weber ). Third, Salisbury and Nenkov () demonstrate in a series of studies a mortality salience effect, such that evoking the concept of death reduces preference for annuities.…”