Just How Puzzling Are Annuities?

Smetters and Reichling are surely correct that people with insufficient means get little benefit from owning annuities. They are also correct that annuities can be purchased much more cheaply after a health shock. But since we are all prone to optimism bias (the expectation that things will turn out well even if not planned out well) and the planning fallacy (our tendency to overestimate our ability to impact and manage the future), and since we routinely and generally tend to underestimate our life expectancy, the need for some form of longevity insurance to make sure we don't run out of money entirely is likely to be much greater than we tend to think.

Examining Biases

Now, since I have brought up our behavioral and cognitive biases, it's also appropriate for me to acknowledge how and where I am prone to them. My skepticism of the Smetters and Reichling research may simply be motivated reasoning on my part. Motivated reasoning is reasoning influenced by financial or other interests that fall in line with a particular point of view. We aren't surprised, for example, that tobacco company executives are far less likely than others to concede the health risks of smoking. Their reasoning is well motivated and well compensated.

While I receive no financial incentive for advocating for any particular financial product or type of product, I have been quite public in my call for greater use of annuitization to provide—together with Social Security and any pension income—a baseline income floor to cover essential retirement needs. My unwillingness to jump on the Smetters and Reichling bandwagon so far may simply reflect my inherent desire to protect my reputation and ego.

My skepticism may also reflect confirmation bias. Confirmation bias is our tendency to see what we want or expect to see. We like to think we act like judges, carefully and dispassionately evaluating all the evidence before reaching a conclusion. Unfortunately, we're much more like lawyers, running around looking for anything that might support our pre-existing positions and that might undermine the opposition. It's why Fox News viewers think those of MSNBC are nuts and vice versa.

My own research and the research of many that I admire and respect has long supported the idea that annuitization should be used far more often than it is. Therefore, my less than full-throated endorsement of the Smetters and Reichling thesis may not reflect a serious problem with their work. It may be nothing more than my own confirmation bias.

Sadly, the greatest risk we face in this area is bias blindness, our ability to see the biases of and in others while being blind to our own. It's why we smile knowingly when the parents of a modestly gifted athlete see an athletic scholarship as virtually inevitable while remaining convinced of the obvious talents of our own children. It is really hard for any of us to change our minds when faced with evidence that contradicts or seems to contradict our firmly held convictions.

While I have read the Smetters and Reichling working paper carefully, I have not vetted it yet; the mathematical modeling that supports it is extensive and fairly complex. I am going to need to do a lot more work on the working paper itself, as well in trying to examine my own biases, to determine how persuasive I think it is. I look forward to the careful analysis and ongoing research of others to help me come to what I hope is a fair and accurate conclusion as to what the paper does and does not show. But it is surely a helpful addition to the literature examining the annuity puzzle, real or imagined.