We came across a new study that looks at some of the behavioral reasons why people tend not to choose lifetime payment (annuity) options - despite the fact that, more often than not, this would be the “rational” thing to do. The study Behavioral Obstacles to the Annuity Market comes from the Pension Research Council at the University of Pennsylvania’s Wharton School.

It’s an academic paper (a difficult read - formulas and all), but we pulled from it some interesting points that may be useful in helping reverse mortgage borrowers better understand the framework within which they make their decisions:

• Mental Accounting - According to the study, the most important reason for annuities being unpopular is mental accounting. Mental accounting refers to the tendency to view financial decisions in isolation rather than within a broader framework of total wealth. People tend to view the lifetime payment decision as an isolated gamble (”will I live long enough to recoup my initial investment”) rather than as a component of a larger retirement funding picture. The study notes:
  

  “If annuity outcomes are segregated from their impact on total retirement spending, then purchasing an annuity appears to be a gamble which increases overall risk, rather than a form of insurance which can reduce risk. In order to combat this problem, annuity marketers and financial advisors need to better frame the annuity as longevity insurance. Having longevity insurance in the form of an annuity should reduce the need for precautionary saving and thus allow annuity holders to consume more in retirement.”

• Availability Heuristic - People are prone to assign greater weighting to “more easily imagined” factors in their assessment of probabilities.
  

  “In the case of annuities, the availability heuristic may play a role in overemphasizing the possibility of dying shortly after the annuity is purchased, because there are many ways an individual can imagine his imminent demise. The likelihood of greatly outliving one’s life expectancy may, on the other hand, not have as much salience, except in those cases where family members or other acquaintances have survived to very advanced ages. This exaggeration of the likelihood of early death would make annuities appear worse…”

• Fear of Illiquidity - People often feel the need to have quick access to cash to take care of emergency needs. With lifetime annuity plans, liquidity is sacrificed in exchange for regular lifetime payments. The study notes:
  

  “(S)imilar to the behavioral mistakes that individuals make when assessing probabilities of dying at early ages, it is quite possible that individuals also overstate the likelihood of catastrophic events that may require sudden spending that could not be met after annuitization.”

In November 2006,we reported on a Boston College study showing that HECM borrowers would best be served by choosing the “lifetime tenure” payment option - an option guaranteeing regular monthly payments to the borrower until loan termination (death, sale of home, etc.). Yet, only about 5% of HECM borrowers actually chose this payment stream. The new Pension Research Council study points to some of the reasons why and can give borrowers valuable insights into their decisions.

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A Few More Related Articles of Interest:

HECM Line of Credit Gains in Popularity Among Reverse Mortgage Borrowers

More From Fidelity: Reasons Why Retirees Avoid Guaranteed Income Options

Study Shows HECM Lifetime Tenure Payment Option is Best Choice

Reverse Annuity Mortgage Can Be a Sensible Strategy

‘Guaranteed Income Gap’ Study Has Implications for Reverse Mortgage Borrowers