“Some macroeconomists say if we just study the numbers long enough we’ll be able to design better policy. That’s like the sign in the bar: Free Beer Tomorrow.”
- Russ Roberts, Economics Professor
LISTEN (mp3 audio) (14:12 min)
One of the assumptions of free-market economists is that fully-informed individuals usually act in accordance with their own interests. In other words, they make financial decisions based on what they believe is best for them. However, sometimes people appear to repeatedly act against their best interests; they act irrationally, even when they have accurate information. Why is this?
In January 2008, four economists working for the National Bureau of Economic Research (NBER) published the results of an extensive study regarding retirement decisions. This information caught the attention of financial writer David Adler, who included some of the findings in his book Snap Judgment: When to Trust Your Instincts, When to Ignore Them, and How to Avoid Making Big Mistakes with Your Money (FT Press, 2009).
The primary feature of the NBER study was a pair of simple one-question quizzes given to 1,300 respondents over the age of 50, with each respondent only answering one quiz. A comparison was then made between the two groups. Because you aren’t part of the study, you can take both quizzes – and see the results!
Here’s the setup:
The quiz involves an evaluation of two fictional, identical individuals, in this case named Mr. Red and Mr. Gray (in all, there were seven fictional persons, with names like Mr. Orange, Mr. Green, Mr. Brown).
- Each person made permanent decisions on how to spend a portion of their money in retirement.
- Each has some savings and can spend $1,000 per month from Social Security in addition to the portion of income mentioned in each question.
- They have already set aside money to leave for their children when they die.
The choices are intended to be financially equivalent and based on personal preferences for spending in retirement. You are asked to evaluate which retirement option represents the “better deal.” Read each choice carefully.
Quiz #1
Mr. Red’s option: Mr. Red can spend $650 each month, along with Social Security, for as long as he lives. When he dies, there will be no more payments.
Mr. Gray’s option: Mr. Gray can choose an amount to spend each month in addition to Social Security. How long his money lasts depends on how much he spends. If he spends only $400 per month, he has money for as long as he lives. When he dies, he may leave the remainder to charity. If he spends $650 per month, he has money only until age 85. He could also spend down faster or slower than each of these options.
Quiz #2
Mr. Red’s option: Mr. Red invests $100,000 in an account which earns $650 each month for as long as he lives. He can only withdraw the earnings he receives, not the invested money. When he dies, the earnings will stop and his investment will be worth nothing.
Mr. Gray’s option: Mr. Gray invests $100,000 in an account which earns a 4% interest rate. He can withdraw some or all of the invested money at any time. When he dies, he may leave any remaining money to charity.
Question: Who has made the better choice?
Mr. Red and Mr. Gray selected different options on how to spend their money in retirement. You are asked to evaluate their decisions.
Can you guess which options were seen as the best in each quiz?
In Quiz #1, 72% felt Mr. Red made the better decision.
In Quiz #2, 79% felt Mr. Gray made the better decision.
But there’s a mind-blowing twist to the study: Each quiz presented the same options! Mr. Red’s plan is the same in both scenarios, and so is Mr. Gray’s!
So, if both plans are the same, why did respondents overwhelmingly choose Mr. Red in the first quiz and Mr. Gray in the second? The answer is “framing.” Our interpretation of new information is dependent in part on the context in which we receive it, i.e., what our “frame of reference” is for a particular scenario. As the NBER researchers put it, “experimental findings suggest that choices are not solely based on material consequences, but instead are filtered through the particular frame that individuals use to interpret choices.”
In these two instances, the “frames” made the difference in the decisions. In the first example, the frame was consumption. The focus was on how much could be spent, and for how long. From this perspective, the emphasis on a larger monthly amount available for consumption, with the guarantee of continuing no matter how long one might live, was seen as most attractive.
The second example was framed by investment. While the numbers remained the same in terms of possible monthly income, the quiz also mentioned that Mr. Red would have access only to the earnings from his investment, and nothing left when he died. In contrast, Mr. Gray had access to his original $100,000 principal at any time, and the prospect of leaving any remainder to heirs.
Analyzing this example, Adler summarizes the effects of framing: “Context can be as important as content when it comes to financial decisions, even very important financial decisions.”
But wait, there’s more…
Beyond the “wow, that’s interesting” factor of the results, both Adler and the NBER researchers believe their study has some significant practical applications.
According to Adler:
“The larger point of the experiment is not just that framing has an impact; it is specifically about how retirement planning is ‘framed’ in the U.S. and how we are conditioned to think about it. Should our financial focus be on building wealth for retirement, or on what we can consume after we retire?”
Jeffrey Brown, one of the NBER researchers, contends we have been conditioned to think about retirement as mostly an investment decision, similar to quiz #2. But in Brown’s opinion, retirement is largely a consumption decision. Says Brown,
“The messages that individuals receive when encouraged to save are all about how much you have in your account and your rates of return. But really you should think about how much can you eat each month, how much can you consume.”
And there’s even more…
If you didn’t already know it, Mr. Red’s retirement decision is a simple description of a lifetime annuity. A life annuity is a relatively straight-forward financial transaction: In exchange for a lump sum payment, an insurance company guarantees monthly payments for your lifetime, no matter how long it may be.
The NBER study (titled “Why Don’t People Insure Late Life Consumption? A Framing Explanation of the Under-Annuitization Puzzle”) is an attempt to explain why some people don’t buy annuities despite their significant financial advantages.
Life annuities are not new. They have a long history, but are infrequently selected by consumers. However, as company pension plans steadily disappear and are replaced by personal accumulation accounts, such as IRAs, 401(k)s, etc., retirees are beginning to reconsider annuities in retirement. But because many potential buyers have an “investment” frame of reference; the idea of “losing” any leftover principal at death is perceived as a strong deterrent to purchasing an annuity.
In contrast, most economists, especially those whose “frame” is consumption, see annuities in a very positive light. You don’t have to worry about outliving your money – ever. If you live beyond your life expectancy, there’s a good chance the guaranteed payments will deliver higher returns than what would have come from traditional investments. Once implemented, there are no management decisions required, and no investment risk. As Adler says, “the wildly enthusiastic consensus among most economists, to say nothing of the insurance industry, is that annuities are a great thing.”
Finally, there’s this…
In spite of all the statistical evidence supporting annuities, there’s still a mental snag for many individuals considering a lifetime annuity. When an annuitant with a lifetime annuity dies, the payments stop (unless a refund feature or term certain feature was elected). There are no refunds of “unused principal.” In a worst-case scenario, someone gives the insurance company a big chunk of change to buy a life annuity, then dies within a short period of time. This possibility, framed from an investment perspective, is probably the biggest reason many people reject a lifetime annuity.
But curiously enough, it seems some of the fears of not living long enough to receive full value from an annuity can be alleviated… by buying one.
Steven Levitt and Stephen Dubner are co-authors of the best-sellers Freakanomics and SuperFreakanomics. Both books take a simple economic idea, that incentives matter, and apply it to a variety of unusual financial, environmental and cultural situations. One of their chapters discusses actions which could lead to a longer lifespan. Among the diverse factors: career choices, winning a Nobel Prize, having a woman doctor…and buying an annuity. Yep, you read that right. Here’s the reason:
“People who buy annuities, it turns out, live longer than people who don’t, and not because people who buy annuities are healthier to start with. The evidence suggests that an annuity’s steady payout provides a little extra incentive to keep chugging along.”
Wow. Based on this evidence, annuities sound like a financial “silver bullet” and a fountain of youth!
But this article really isn’t about annuities…
Whether or not you should buy an annuity depends on your unique circumstances.
A greater issue is who or what is framing your financial decisions, and whether that frame is the most beneficial perspective for you and your future.
A parallel issue, one that may offend some sensibilities, is whether all frames are equally viable. Specifically, are the consumption and investing frames just two approaches to the same objective, or is one better than the other?
While historical and mathematical arguments can be made for either the consumption or investing frame, there is strong psychological support for the consumption paradigm. In March, the Employee Benefits Research Institute (EBRI) released its 20th annual report on retirement confidence. One of their findings: “Nearly half of all workers would opt for a guaranteed income for life.”
Perhaps this inclination toward security is primarily a reaction to the recent financial turmoil. But more likely, it points to the real value of financial security. Maximized consumption isn’t just a framing option. It’s the better choice for financial success and contentment.
DO YOUR FINANCIAL OBJECTIVES INCLUDE A CONSUMPTION FRAME OF REFERENCE?
HOW MUCH OF YOUR FINANCIAL FUTURE IS SECURED?
