February 23, 2008
The Undercover Economist: It’s the way they sell ’em
Here’s what I like about insurance: you pay the insurers money when you do not desperately need it, and then the insurers pay you money just when you need it most.
Curiously, this is not what other people seem to like about insurance. Most people do not try to arrange for insurance payments to arrive when they will need them most. Instead, they arrange for insurance payments to arrive after bad luck.
If your house has just burnt down, “when you need money most” amounts to the same thing as “after bad luck”. But what if your son has just been accepted by Eton, and his older sister by Harvard? That is when the money would be useful, but we are temperamentally more inclined to insure against the tragic death of a child. It goes against the grain to insure against “good news”.
The remainder of this column can be read here. Comments can be posted below.
A lack of willingness to buy annuities can actually make sense in a classical economics framework if you bear in mind that it’s very difficult to buy annuities with an income stream that isn’t guaranteed in nominal or real terms. Current annuities do not allow you to take market risk AND protect against mortality risk.
You may be quite happy to take some income risk in your retirement if there is upside potential. For example, you may want to partially invest in equities as you are rewarded in expected value terms (the equity risk premium is positive).
I did some calculations last year based on my risk/return preferences, best estimate mortality prices, current annuity market costs, and some theory in a paper my Milevsky and calculated that I shouldn’t annuitize at all until age 77, after which I should be fully annuitized. I was pretty conviced by the reasoning: by annuitizing at age 65 you forego 12 years of exposure to market risk, at an age when mortality rates are pretty small compared to the equity risk premium.
Posted by: Daniel | February 25th, 2008 at 2:09 pm | Report this comment