Behavioural bias to doom lifetime annuities

The financial services industry needs to acknowledge and work within the confines of behavioural biases, such as loss aversion, according to Milliman.

In an analysis, the actuarial provider’s principal and senior consultant, Wade Matterson, said retirees were five times more sensitive to losses as their savings were usually at their peak and their ability to ride out any losses was far lower than when they were in the workforce.

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“To put it in dollar terms, losing $1000 for a retiree is as painful as the satisfaction received from gaining $5000. A substantial number of retirees were even more hyper averse to losses,” Matterson said.

“Nearly half of retirees said that they would refuse a gamble with a 50 per cent chance of winning $100 and a 50 per cent chance of losing as little as $10, suggesting they weighted losses about 10 times more heavily than gains, according to an AARP and the American Council of Life insurers study.”

He said this emotional bias was a prime reason investors withdrew funds at poor times and often locked in losses or ended up over-paying for assets.

“But while retirees in particular show extremely high sensitivity to losses, they also shy away from guarantees that require giving up control,” Matterson said.

“Typical products designed to minimise losses and deliver guaranteed income, such as annuities, were particularly unpopular among retirees displaying hyper loss aversion.”

He said few Australians purchased either lifetime or fixed term annuity produces and at least 94 per cent of pension assets were in account-based pensions.

“These retirees typically withdraw the minimum pension legally required, attempting to live frugally to protect themselves against the risk of outliving their savings,” he said.

Matterson noted the behavioural biases meant that a purely rational solution, such as offering lifetime annuities which ignored the realities of investor behaviour, was doomed to fail.

He said a combination of flexible products which managed the risk concerns of retirees in a more nuance manner, financial advice, education, and truly flexible and effective risk management practices would be able to control loss aversion bias to allow investors to reach their retirement goals.