We know that one way to draw down wealth in retirement is to stay invested while taking income. Since this can be a daunting task to do on your own, without the help of a financial advisor, and because more of us are risk-averse, one would think that annuities might be a more popular option. Yet the size of the annuities market, $1.9 trillion, is a far cry from the nearly $9 trillion parked in individual retirement accounts (IRAs) and employer-sponsored defined contribution (DC) plans.
The debate on why annuities are not more popular is ongoing. Cost is often raised as an objection, yet fees and charges alone are unlikely to explain the low annuity adoption.
As for behavioral reasons, an annuity purchase usually requires taking some action, such as comparison shopping. Considering the wide range of choices available and complexity of many of these products, even small steps like making a phone call can be overwhelming. That’s why annuities included in DC plans tend to have higher adoption rates.
Framing also matters. Framing an annuity as an investment rather than as future spending tends to reduce its perceived attractiveness, as its “return” depends on the age at death. Also, while economists think of annuities as a risk-reducing strategy that helps smooth out a future consumption stream, an individual may feel like he’s taking a big lump sum, which he perceives as (nominally) guaranteed, and gambling it on an annuity whose value is contingent on how long he lives. This can be especially damning for a loss-averse investor.
Finally, according to the endowment effect, once you own something, you’re reluctant to give it up even for an identical thing. In the same way, having to write a check in a DC plan to buy an annuity may appear unappealing. This is especially true for an unsophisticated investor for whom the loss of a large sum of money today may mentally dominate a number of small payments to be received in the future.
How can individuals shift their investment behavior from accumulating a nest egg to spending in retirement?
The task of bridging the gap between our lump sum savings and the life outcomes most of us are saving for may seem intimidating. To start, it helps to focus on how much we want to spend in the future, rather than how we should invest our retirement accumulations or what kind of financial products may best achieve our objectives.
Many people derive comfort from thinking about an income stream that is relatively stable over time, even it if implies putting off current spending. Annuities, as I’ve discussed, are one way to convert at least a portion of a nest egg to a lifetime income stream. Tools such as BlackRock’s CoRITM can help estimate how much retirement income could be generated when annuitizing one’s current savings.
Yet even for those who choose not to annuitize, the ability to visualize a monthly or annual payment can result in more thoughtful planning around asset allocation, when to retire and how to appropriately draw down savings.
Nelli Oster, PhD, is a Director and Investment Strategist in BlackRock’s Multi-Asset Strategies Group. She writes about behavioral finance for The Blog and you can find more of her posts here.