Academic journal article Journal of Risk and Insurance

Multiple Reference Points and the Demand for Principal-Protected Life Annuities: An Experimental Analysis

Academic journal article Journal of Risk and Insurance

Multiple Reference Points and the Demand for Principal-Protected Life Annuities: An Experimental Analysis

Article excerpt


We conducted an experiment in which participants were confronted with an experimental annuitization decision. Previous research has argued in favor of the hypothesis that a combination of mental accounting and prospect theory can explain why annuities containing a capital guarantee are preferred to standard annuities. However, from this perspective people would not annuitize their assets at all, but rather invest the money in a risk-free alternative. Recent research has also suggested a "cushion effect." When all possible outcomes of two options are above a certain goal, this goal serves as a cushion in case of unfavorable outcomes. Hence, individuals might have a higher propensity to exhibit risk-seeking behavior. We find that individuals were indeed more willing to choose the annuity option if it contained a capital guarantee and that individuals using this guarantee as a cushion were even more wilting to choose the annuity. Thus, the cushion effect can partially explain the high demand for guarantee features in annuity contracts.


Life annuities generate a predefined income stream to the end of the policyholder's life. Unlike other investment products, they provide insurance against the individual longevity risk of outliving one's assets. Yaari (1965) shows that under quite restrictive assumptions, expected utility-maximizing investors will find it optimal to completely annuitize their wealth. However, annuity markets are rather thin all over the world, which is puzzling in the light of this optimality result. There are a number of potential factors, such as incomplete annuity markets, transaction costs, bequest motives, adverse selection in annuity markets, and existing annuities from social security, that might be able to explain the annuity puzzle within an expected utility framework (Brown, 2007). However, Davidoff et al. (2005) show that the main result still holds after relaxing many of Yaari's original assumptions. They conclude that "the absence of annuitization outside of Social Security and defined-benefit pensions cannot easily be explained within a rational life-cycle model" and suggest that "lack of annuity demand may arise from behavioral considerations."

Hu and Scott (2007) examine the demand for annuities from a behavioral economics perspective, referring to the literature on mental accounting (Thaler, 1999) and framing (Tversky and Kahneman, 1981; Read et al., 1999). From this perspective, an immediate annuity purchased at the beginning of retirement is evaluated in a separate mental account. It is not considered as insurance against longevity risk but rather as an investment. The annuity is viewed as a bet on the policyholder's own life, since the level of total repayment depends on when he dies. The bet is then viewed as only being profitable if he lives long enough to recoup the invested amount. Due to loss aversion, the potential losses in the case of an early death outweigh the possible gains when he lives longer than expected and hence the annuity is rejected. (1)

Brown et al. (2008) find evidence that the framing of annuities and other financial products can influence individuals' investment decisions. These products were presented by them to roughly half of the participants in a survey using a consumption frame that highlighted the impact on consumption over lifetime. The insurance characteristic of the annuity concerning longevity risk therefore became salient. In this treatment, annuities were strongly preferred to other types of financial products. For the other half of the survey participants, the annuity and the alternative financial products were presented in an investment frame focusing on risk and return. Savings accounts and other financial products were strongly preferred to annuities in this framing. Gazzale and Walker (2009) argue that the "hit-by-bus" concern, the worry about dying soon after the annuitization date and thus losing money to the insurance company, might enforce the aversion against annuities. …

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