After last week's intense, if short-lived, stock-market crash, immediate fixed annuities might be looking good, especially to older investors. In fact, a new study finds that investors tend to base their annuity decisions on very recent market trends, making them more likely to annuitize during a market drop. But that approach can take a big toll on your retirement wealth.
With an annuity, an investor trades a large lump sum of money for a stream of monthly income for life. It's often a difficult decision for investors because the choice is irreversible. In an ideal world, a retiree would annuitize their savings when their portfolio has increased in value, because it gives them the opportunity to sell their stocks, collect the gains and exchange them for a larger monthly annuity payment.
But Alessandro Previtero, a finance professor at University of Western Ontario, found that investors do just the opposite: Frightened by market declines, they are more likely to annuitize when their portfolios have taken a hit. Meanwhile, when the market is rising, investors avoid annuitizing because they expect further gains.
In short, fear and greed rule the day. Just as investors make the mistake of selling their stocks when the market dives and buying -- or hanging on to them -- when it rallies, annuity buyers do the same thing. "If employees have additional resources invested in the stock market, positive returns can make them wealthier and less risk averse and, hence, decrease the value of choosing an annuity," Previtero writes.
What Bad Timing Could Lose You
Previtero investigated the relationship between the annuity decision and the stock market across several sets of data, including the actual pay-out decisions of more than 103,000 retirees between 2002 and 2008. They were enrolled in 112 different defined benefit plans at 63 companies. Some 49% of employees chose an annuity instead of a lump-sum payout.
To gauge investor expectations of the stock market during that period, Previtero used at a confidence index that measured the percentage of individual investors who anticipated a rise in the Dow Jones Industrial Average in the coming year. A 1-percentage-point increase in the index corresponded to a nearly 10-percentage-point drop in the probability of purchasing an annuity.
Previtero also looked at immediate-annuity-purchase data collected by LIMRA International from 1985 to 2009. After controlling for interest rates and business cycles, Previtero found that an increase of 1 percentage point in the average stock-market return decreases the total sales of fixed annuities by more than 5%.
"Recent stock-market returns can affect beliefs about future returns," Previtero writes. "After negative returns, employees might believe that this trend will continue in the future and, consequently, are more attracted to the annuity, essentially a fixed-income financial product. The opposite can happen after a positive trend in the market."
Previtero analyzed the outcomes for two theoretical employees: one considering an annuity before the credit crisis in December 2007 and the other making the same decision in December 2008. "Holding everything else equal, my estimates imply that the employee retiring in December 2008 is about 25 percentage points more likely to choose an annuity," he writes, translating into a 5% to 10% loss in that person's overall retirement assets.