Who Prefers Annuities? Observations About Retirement Decisions

As baby boomers retire, they must decide how to receive payouts from their defined benefit (DB) plans, defined contribution (DC) plans and personal savings. Many pension experts believe that life annuities are the best way for retirees to ensure that they don’t run out of money. But most people do not choose annuities, and experts are wondering why. To find out, Watson Wyatt Worldwide asked a national panel of older workers and recent retirees about their payout and risk preferences, retirement decisions and related issues. Our observations are based on the 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

According to the surveys, several factors influence workers’ and retirees’ preferences and choices. One, retirees covered by DB plans or by both DB and DC plans are more likely to receive an annuity (although they may also receive a lump sum). Retirees with only a DC plan, however, overwhelmingly receive their benefits in a lump sum. Two, the amount of the lump sum relative to the annuity value affects participants’ preferences. Three, older employees’ preferences differ by gender, marital status, education and salary level, but the differences are less pronounced among retirees. Four, unsurprisingly, people who believe they are in better health and those who expect to live longer are more likely to choose annuities. Five, being more risk-averse seems to make workers and retirees more likely to prefer an annuity.

Annuity Decisions Within Retirement Plans
Plan type exerts a powerful influence on how benefits are paid out in retirement. Table 1 shows the distribution of older workers by plan type and the percentage of older workers who intend to receive at least some of their retirement benefits as an annuity. Because employees from large firms are overrepresented in our survey, many employees are covered by both a DB and a DC plan.

Of older workers who have only a DB plan with their current employer, about 93 percent plan to receive an annuity. Of those with only a DC plan with their current employer, only about 7 percent intend to take an annuity, probably in part because most DC plans do not offer an annuity option.¹ Roughly 79 percent of those with both a DB and a DC plan anticipate taking at least some of their retirement income as an annuity.

Table 1
Older Employees Planning to Receive Annuity by Plan Type

	Percentage of employees with retirement plan	Percentage of employees planning to receive at least some benefit as annuity
DB plans only	7.4%	92.5%
DC plans only	5.0%	6.5%
DB and DC plans	76.9%	78.6%
No retirement plan	10.7%	--

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

We also asked recent retirees how they receive their retirement benefits. Table 2 shows the distribution of retirees by plan type and the percentage who receive any retirement benefits as an annuity. Roughly 76 percent of retirees with only a DB plan receive annuity payments, while approximately 12 percent of those with only a DC plan receive annuity payments. Seventy-four percent of retirees who receive benefits from both DB and DC plans receive annuity payments.

Table 2
Retirees Who Receive Annuity by Plan Type

	Percentage of retirees with retirement plan	Percentage of retirees that receive at least some benefit as annuity
DB plans only	17.8%	76.3%
DC plans only	20.8%	12.1%
DB and DC plans	43.4%	74.0%
No retirement plan	18.0%	--

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

Lump Sum Amounts and Annuity Preferences
To determine the effect of lump sum size on the preferences, we asked participants whether they would rather have an annuity of $1,000 per month or an annuity of $500 per month plus a lump sum. Based on the average ages of older employees and retirees, we determined lump sums on a unisex basis that were actuarially fair and equivalent to an inflation-indexed life annuity.

Figure 1 shows the choices older employees think they would make at age 65. Roughly 58 percent would prefer $500 per month plus a $111,000 lump sum, while 42 percent would opt for $1,000 per month.

Figure 1
Older Workers’ Choices Between Larger Annuity and Smaller Annuity Plus a Lump Sum

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

Similarly, Figure 2 shows the choices retirees think they would make at age 75 between $1,000 per month and $500 per month plus a lump sum of $80,500. Again, the majority – 56 percent – would prefer a combination of an annuity and a lump sum. Perhaps most employees and retirees believe that receiving both payment types provides a good balance of spending flexibility and security.

Figure 2
Retirees’ Choices Between Larger Annuity and Smaller Annuity Plus a Lump Sum

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

We then asked follow-up questions to find out how participants would choose when the lump sum values were not actuarially equivalent to the inflation-indexed annuity. We asked participants who chose an annuity in the first hypothetical question whether a higher lump sum would change their mind. Similarly, we asked participants who chose the annuity-lump sum combination in the first hypothetical question whether they would have chosen differently had the lump sum been smaller. Many older employees would still prefer the annuity-lump sum combination, but for some, their preference varies according to the lump sum amount. Figure 3 shows the results of all older employees’ choices.

Most employees want a lump sum — if it’s big enough. The majority of employees want an annuity — if the lump sum is too small. Only about 27 percent say they would choose the annuity regardless of the lump sum amount, and only 36 percent say they would always opt for the annuity-lump sum combination.

Figure 3
Effect of Lump Sum/Annuity Amounts on Older Workers’ Choices

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

We also asked retirees similar follow-up questions. Again, the size of the lump sum affected their decisions, although many retirees would prefer both the lump sum and an annuity. Figure 4 shows the results for the retirees.

Figure 4
Effect of Lump Sum/Annuity Amounts on Retirees’ Choices

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

Personal Characteristics and Annuity Preferences
Previously published reports on annuities show that people with certain personal characteristics are more likely to choose an annuity over a lump sum payment, and our study finds similar results. Table 3 shows the distribution of older workers by gender, marital status and education, and the percentages of those who chose the annuity and those who chose the annuity-lump sum in response to our hypothetical survey question. Older workers who are female, unmarried and do not have a college degree were more likely to choose the annuity as their only payment option.

When we asked retirees the same question, however, the differences in characteristics between those who chose the annuity and those who chose the annuity-lump sum combination are less significant. Table 4 shows the distribution of retirees by gender, marital status and education and the percentages of those who chose the annuity and those who chose the annuity-lump sum combination based on the hypothetical question. There is no significant difference between males and females or between those with and without a college degree. Unmarried retirees, however, were slightly more likely to choose an annuity than married retirees.

Table 3
Comparison of Older Workers Who Chose Annuity Versus Those Who Chose the Annuity-Lump Sum Combination by Gender, Marital Status and Education Level

	Male	Female	Married	Not married	Have some college experience or less	Have college degree of higher education
$1,000/month	38.4%	46.1%	39.4%	48.7%	44.1%	38.9%
$500/month and $111,000	61.6%	53.9%	60.6%	51.3%	55.9%	61.1%
Total	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

Table 4
Comparison of Retirees Who Chose Annuity Versus Those Who Chose the Annuity-Lump Sum Combination by Gender, Marital Status and Education Level

	Male	Female	Married	Not married	Have some college experience or less	Have college degree of higher education
$1,000/month	43.4%	45.6%	42.6%	48.1%	45.5%	42.3%
$500/month and $111,000	56.6%	54.4%	57.4%	51.9%	54.5%	57.7%
Total	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

Table 5 shows the distribution of reported earnings for older workers. Older workers who prefer to receive only an annuity have lower reported earnings than those who prefer the combination. The difference between the median values is $4,000, and the difference between the average reported earnings is $5,124.67.

Table 5
Distribution of Salary for Employees Who Chose Annuity and Employees Who Chose the Annuity-Lump Sum Combination (all salaries are greater than $5,000)

	Reported Annual Salary
	25th percentile	50th percentile	75th percentile	Average
$1,000/month	$28,000	$46,000	$71,000	$54,349.26
$500/month and $111,000	$32,000	$50,000	$73,941	$59,473.93

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

Longevity, Health Status and Annuity Choices
As individuals age, they face an increased risk of health shocks that may shorten life expectancy. Thus, the expected value of an annuity decreases as life expectancy shortens. When the risk of death is substantial because of poor health, an annuity is no longer an optimal form of retirement income. So the decision between an annuity and a lump sum payment is greatly influenced by an individual’s self-perceived health status and life expectancy.

To determine how optimistic older workers and retirees are about their life expectancy and how much they value longevity insurance, we asked them whether they expect to live to ages 75, 85 and 95 (Table 6). Approximately 47 percent of older workers believe they have a 100 percent chance of living to age 75, while only about 5 percent feel certain that they’ll make it to 95.

Table 6
Older Employees’ Self-Reported Expectations of Reaching Ages 75, 85 and 95

	Expect to live to 75	Expect to live to 85	Expect to live to 95
No chance	2.5%	9.5%	30.2%
25% chance	5.5%	17.5%	28.6%
50% chance	21.0%	27.0%	24.7%
75% chance	24.5%	31.0%	11.4%
100% chance	46.5%	15.0%	5.1%
Total	100.0%	100.0%	100.0%

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

We also look at retirees’ expectations of living to ages 85, 90 and 95. Similar to older workers, retirees are less optimistic about their life expectancy at older ages. Although about 18 percent believe they have a 100 percent chance of living to age 85, only 7 percent feel certain they will reach 95. More than half the retirees believe they have no chance of living to 95.

Table 7
Retirees’ Self-Reported Expectations of Reaching Ages 85, 90 and 95

	Expect to live to 85	Expect to live to 90	Expect to live to 95
No chance	16.5%	30.2%	52.6%
25% chance	18.6%	26.5%	16.4%
50% chance	28.3%	21.2%	16.1%
75% chance	19.1%	16.3%	8.0%
100% chance	17.5%	5.9%	7.0%
Total	100.0%	100.0%	100.0%

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

We then cross-tabulate the ways that older employees plan to receive their retirement income with their self-assessed probability of reaching age 85 (Table 8). Older workers who believe they have no chance of reaching 85 are more likely to opt for a lump sum-only benefit than those who believe they have a 100 percent chance of reaching 85 (35 percent versus 29 percent).

Table 8
Older Employees’ Expected Payment From Retirement Plans and Probability of Reaching Age 85

	No chance	25% chance	50% chance	75% chance	100% chance
Receive retirement income as lump sum	34.5%	27.6%	30.7%	30.2%	29.4%
Receive at least part of retirement income as annuity	65.5%	72.4%	69.3%	69.8%	70.6%
Total	100.0%	100.0%	100.0%	100.0%	100.0%

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

A similar cross-tabulation for retirees shows that approximately 55 percent of retirees who do not expect to live to age 85 took a lump sum payment. However, only about 47 percent of retirees who think they have a 100 percent chance of living to 85 opted for the lump sum only.

Table 9
Retirees’ Expected Payment From Retirement Plans and Probability of Reaching Age 85

	No chance	25% chance	50% chance	75% chance	100% chance
Receive retirement income as lump sum	55.3%	58.3%	48.5%	47.2%	46.8%
Receive at least part of retirement income as annuity	44.7%	41.7%	51.5%	52.8%	53.2%
Total	100.0%	100.0%	100.0%	100.0%	100.0%

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

We also look at the effects of current health status on retirement choices. Table 10 shows a cross-tabulation between the way older employees plan to receive their retirement income and their self-reported health status. Sixty-six percent of older employees in excellent health would prefer to receive at least part of their retirement income as an annuity, compared with 53 percent of older employees in poor health.

Table 10
Effect of Health Status on Older Workers’ Annuity/Lump Sum Decisions

	Excellent	Very good	Good	Fair	Poor
Receive retirement income as lump sum	33.6%	29.5%	32.8%	53.6%	46.8%
Receive at least part of retirement income as annuity	66.4%	70.5%	67.2%	46.4%	53.2%
Total	100.0%	100.0%	100.0%	100.0%	100.0%

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

Table 11 shows the relationship between retirees’ retirement income choices and their self-reported health status. Fewer than half of retirees in good health or better took all their retirement income as a lump sum (between 45.9 percent and 47.2 percent). However, roughly 77 percent of retirees in poor health opted for a lump sum alone.

Table 11
Effect of Health Status on Retirees’ Annuity/Lump Sum Decisions

	Excellent	Very good	Good	Fair	Poor
Receive retirement income as lump sum	47.2%	47.3%	45.9%	63.3%	76.9%
Receive at least part of retirement income as annuity	52.8%	52.7%	54.1%	36.7%	23.1%
Total	100.0%	100.0%	100.0%	100.0%	100.0%

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

Most Retirees Are Risk-Averse
Retirees face several risks that affect their optimal retirement age and form of retirement income. These risks include losing a spouse, realizing poor investment performance, being hit with unexpected medical expenses and outliving their income. To better understand how people plan for the unforeseen, we asked some questions whose answers serve as a proxy for risk aversion.

We first asked older employees and retirees to choose between a guaranteed annual salary of $110,000 and a variable annual income with a 90 percent chance of being $90,000 and a 10 percent chance of being $190,000. The answer suggests the individual’s tolerance for risk.

Seventy-one percent of employees and almost 73 percent of retirees chose the guaranteed salary. Figures 5 and 6 show the percentage breakdown for employees and retirees, respectively. It appears that most people are more strongly motivated by security than by a chance for more money.

Figure 5
Older Workers’ Choices of Steady or Variable Job Payments

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

Figure 6
Retirees’ Choices of Steady or Variable Job Payments

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

We then asked participants to choose between two variable-income payments, one of which is riskier than the other. Figure 7 shows how older employees responded to the two questions. A large majority – more than 60 percent – prefer to have lower-risk income. The retirees’ responses are not shown, but indicate similar attitudes.

Figure 7
Effect of Possible Higher or Lower Income on Older Workers’ Payment Choices

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

Risk-Averse Retirees Prefer Annuities
Risk-averse workers and retirees prefer annuities over lump sums, according to the economic and retirement literature. We looked for a relationship between workers’ and retirees’ retirement distribution of preference and their level of risk aversion, as represented by respondents’ choices of either a steady guaranteed income or a possibly higher variable income, and then between different variable income payments.

We used three categories to measure levels of risk aversion: risk-loving, mixed and risk-averse. Risk-loving describes respondents who chose the variable salary in both situations. Mixed includes respondents who chose the steady income in one situation and the variable income in the other. Risk-averse describes respondents who chose guaranteed income payments in both situations.

Employees who are more risk-loving generally chose the annuity and lump sum combination, regardless of the amount of the lump sum (see Table 12). However, employees who are mixed or risk-averse tend to prefer the lump sum/annuity combination in one situation, but the annuity in another, depending on the lump sum amount. Roughly 38 percent of mixed older workers and about 40 percent of risk-averse older workers are “in between” – they chose the annuity in one situation and the annuity-lump sum combination in another.

Table 12
Effect of Older Employees’ Level of Risk Aversion on Payment Choices

	Chose annuity-lump sum combination in both questions	Chose combination in one question, annuity in the other question	Chose the annuity in both questions	Total
Risk-Loving	50.1%	25.3%	24.6%	100.0%
Mixed	36.6%	37.9%	25.5%	100.0%
Risk-Averse	32.4%	40.2%	27.4%	100.0%

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

Most retirees, however, prefer the lump sum and annuity combination regardless of their risk-aversion level (Table 13).

Table 13
Effect of Retirees’ Level of Risk Aversion on Payment Choices

Source: Watson Wyatt Worldwide 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

Conclusion
Several factors influence whether employees and workers receive a lump sum or an annuity. Retirement plan type plays an important role – participants with only a DC plan are less likely than those with a DB plan to receive an annuity. As coverage of DB plans becomes scarcer and more workers have only a DC plan, more retirees could be at risk of outliving their resources.

The lump sum amount generally influences workers’ and retirees’ decisions. Risk aversion plays a significant role in people’s choices – those who are more risk-averse tend to prefer annuities to lump sums. Also, health status and longevity expectations affect the desirability of annuities. We find that people who are healthier and who expect to live longer prefer annuities over lump sums.

But many people are subject to various other influences, suggesting that an annuity plus a lump sum is often the distribution form of choice. That option offers a mix of security and flexibility, giving retirees both cash – to deal with unexpected events – and a steady guaranteed income.

One influence that all people are subject to is Social Security. For some workers, Social Security will be a significant portion of their retirement income, while for others it will constitute a much smaller share. Thus, people might want an annuity that, when combined with Social Security, is sufficient to pay their monthly bills. Also, Social Security is inflation-adjusted, while most commercial and pension annuities are not.

As companies become more aware of their employees’ needs, they may decide to offer new options, such as making annuities available from DC plans. More annuity products might become available and should be examined carefully by plan sponsors. And employees might choose to purchase commercial annuities to minimize their retirement risks.

Changing pension laws also play a role. The Pension Protection Act of 2006 will effectively reduce the value of lump sums paid from DB plans while holding the value of annuities steady. As intended, lower lump sum values will likely nudge more workers toward annuities.

Moreover, market volatility in the stock market has made investing in DC plans and IRAs less attractive, which could make annuities more attractive. Lower interest rates make annuities more expensive — the opposite effect — which could make people less willing to purchase annuities.

However, many new DC annuity products allow workers to purchase an annuity while they’re still working, which mitigates the interest rate risk, and some have guarantees that limit the risk of market volatility. And, of course, appropriate diversification limits retirees’ equity exposure and can also hedge interest rate risk.

About the Surveys
Watson Wyatt’s 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans were conducted in May 2007. The surveys were completed by approximately 2,600 employees and 2,400 retirees separately. Almost half the employees in the sample were matched to their specific plan design using the Watson Wyatt COMPARISON^TM database. The age range of the older workers was 50 to 65 and the average age was 55.8. The age range for retirees was 60 to 75 and the average age was 65. The survey weights are designed by post-stratifying to the March 2006 Current Population Survey data using probabilities based on sex, age, marital status and having a pension plan. More details will be available in a forthcoming technical report.

¹ About 28 percent of DC plans offer any sort of annuity option, according to the 2005-2006 COMPARISON™ survey of plan sponsors.