Driving by Looking in the Rearview Mirror : Stock Returns and Annuitization at Older Ages

We investigate the decision to annuitize retirement savings in a novel dataset with over 100,000 actual payout decisions. We document a robust negative relationship between very recent stock returns and annuitization. After controlling for several standard explanations (e.g., wealth effects), we present evidence supporting naïve beliefs and extrapolation from past returns. The effect of recent returns on annuitization dramatically increases with age, confirming that the elderly rely most heavily on recent information. Our results provide insights into how beliefs are formed in old age and have implications for the design of public policies seeking to promote annuitization. JEL Classifications: D14, G11, G22, H55 ∗Alessandro Previtero is Finance Assistant Professor and MBA ’80 Faculty Fellow at the Ivey Business School, University of Western Ontario. Earlier versions of this paper were titled “Stock Market Returns and Annuitization”and “Stock Market Returns and Annuitization: a Case of Myopic Extrapolation. ”I would like to thank Shlomo Benartzi, Antonio Bernardo, Bruce Carlin and Mark Grinblatt for their useful comments. I’m also grateful to Sebastien Betermier, Walid Busaba, James Choi, Timothy Conley, Dora Costa, Amy Finkelstein, Steve Foerster, Andreas Fuster, Mark Garmaise, Hanno Lustig, Brian Melzer, Olivia Mitchell, Javier Perez-Estrada, Eduardo Schwartz, Albert Sheen, Stephan Siegel, Rossen Valkanov; participants at the Russel Sage Summer Institute in Behavioral Economics; seminar participants at UCLA, University of Washington, Notre Dame University, University of Western Ontario, HEC Montreal, University of Amsterdam, University of Mannheim; participants and discussants at 2010 Netspar International Pension Workshop, 2010 Northern Finance Association Meetings, 2011 SOBDR Conference at University of Toronto, 2011 Boulder Summer Conference on Consumer Financial Decision Making, 2011 Behavioral Finance Academy Annual Conference, 2011 CFS-EIEF Conference on Household Finance, 3rd Annual Behavioral Finance Conference at Queen’s School of Business. For providing data used in this paper, I’m indebted to an anonymous data provider; Federico Castellanos and Kathleen Roin from IBM; Matthew Drinkwater from Limra International; and Robert Shiller from Yale University. For comments, contact Previtero by e-mail at: aprevitero@ivey.uwo. ca. What are the determinants of the decision to annuitize retirement savings? With over 31 million Americans expected to retire within the next 10 years (Reno and Lavery, 2009), this question is of great academic and practical interest. In defined benefit plans, employees traditionally receive at retirement lifetime income payments in the form of an annuity. In defined contribution plans, the most common type of retirement plan today, retirees have greater autonomy but directly bear the risk of outliving their retirement wealth.1 By providing lifetime guaranteed income, annuities are a straightforward way to insure this longevity risk. Economists have been investigating annuitization decisions for almost 50 years (Yaari, 1965), yet empirical evidence is still limited (for a review, see Brown, 2007 or Benartzi, Previtero and Thaler, 2011). This paper helps to fill this void by documenting the significant effect of recent stock returns on the decision to annuitize. In our main specification, we find that a one standard deviation variation in recent stock returns impacts the likelihood to annuitize by about 50 percent more than the effect of gender (6.2 vs. 4.2 percentage points). Annuity sales fluctuate substantially over time. The booms in annuity sales after the recent financial crisis and in the aftermath of the dot-com bubble suggest that past stock market returns might influence the decision to annuitize. In Figure 1, we plot quarterly data from fixed individual annuity sales (in real dollars) and stock returns from the preceding twelve months. The negative correlation between the two time-series is striking (-0.748). [Insert Figure 1 here] 1To understand the potential magnitude of this risk, we can look at the distribution of life expectancy at age 65 from the tables provided by the Social Security Administration. The difference between the 10th and 90th percentile of this distribution is equal to 22 years for men (dying at age 70 versus 92) and 23 years for women (dying at age 72 versus 95).