Are Cognitive Constraints a Barrier to Annuitization?

With the shift from defined benefit pensions to 401(k) plans, individuals are increasingly responsible not only for saving for retirement but also for drawing down their assets in retirement. These drawdown decisions require substantial cognitive effort and are very difficult for the average person. Yet most models of asset decumulation ignore the possibility that individuals may differ in their decision-making abilities. Indeed, many models suggest that consumers facing the risk of outliving their resources should find annuities of substantial value, but few people buy them. Researchers have advanced a host of plausible explanations for the limited take-up. But no single factor, or combination of factors, has solved the puzzle. This brief, based on a recent study, examines whether consumers do not buy annuities because they find them hard to value. Specifically, this research explores whether individuals differ in their ability to value a stream of annuity income relative to a lump sum, and whether this ability is correlated with measures of cognitive ability. These findings raise questions about whether consumers are able to make well-informed choices when confronted with a decision about whether to buy an annuity. The discussion proceeds as follows. The first section briefly reviews the annuity literature. The second section describes an experiment to identify how difficult it is for individuals to value an annuity. The third section presents the results of the experiment. The final section concludes that annuities are hard for individuals to value, particularly those with lower cognitive ability.