Investors and economists do not share the same opinions about annuities. Economists like annuities because they transfer the risk of outliving one’s savings to a third party (meaning an insurer). Individual investors, however, commonly do not view these products in the same manner.

In an attempt to understand the reasons why, the Center for Retirement Research at Boston College (CRR) looked to see if there is a cognitive bias against annuities. Specifically, CRR researchers sought to determine if investors dislike annuities because they find them hard to value.

The researchers asked 2,210 individuals to value hypothetical changes in their monthly Social Security benefit. Study participants were asked how much they would pay to raise their monthly benefit by $100 and how much they would demand in exchange for a $100 decrease. In both instances, the initial offer was $20,000 and was adjusted based on the amount a respondent was willing to transact at. In theory, the transaction amount for receiving a $100 per month boost or accepting $100 per month reduction should be the same; the results proved otherwise.

The median price the study’s participants were willing to pay for an additional $100 monthly benefit was $3,000. On the other hand, participants demanded a median compensation of $13,750 in exchange for a $100 reduction. To put these numbers in perspective, the lifetime value of a $100 monthly Social Security benefit is $16,855. The researchers say this experiment shows the difficulty investors have in valuing annuities. By not comprehending the value of a future stream of income, investors lack the ability to determine if an annuity is a good choice or not.

The researchers further found that altering how the question was asked changed how participants valued the change in benefits. Specifically, offering an initial lump sum of $30,000, instead of $20,000, increased the median amount participants demanded for a $100 per month benefit cut. The researchers say this behavior is further evidence that many investors have difficulty assessing the actual value of an annuity.

Source: “Are Cognitive Constraints a Barrier to Annuitization?” Jeffery Brown, Arie Kapteyn, Erzo Luttmer and Olivia Mitchell, Center for Retirement Research at Boston College, March 2015, Number 15-6.