There's been a lot written recently about the "annuity anomaly." You know what that is. That's the idea stating the "rational man" will buy an annuity under certain, specific circumstances. That's what all those fancy academic experiments tell us. Trouble is, once you move those certain, specific circumstances off the blackboard and into the real world, people behave differently. 

Now, I know what you're thinking. You're thinking, "Oh, this is just another one of those articles about the well-documented problems with Modern Portfolio Theory." If that's what you're thinking, then this is what I say to you (in my best Nelson Muntz – he's the bully on the Simpsons – impersonation): "Ha ha!" 

Don't be fooled by my use of the term "rational man." Yes, that's an artifact from MPT. Yes, much of what has been learned from behavioral finance has shredded the concept behind that term. Ironically, though, it is that same area of study that proclaims investors should buy annuities. They don't actually use the term "rational man," but their conclusions, when compared to what happens in day-to-day living, has the imprimatur of the "rational man." It's like those behavioral professors are saying, "people behave irrationally, but in predictable ways." 

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One of the latest research papers that attempts to explain the annuity anomaly is profiled in "Why a 401k Fiduciary Must Convince Retirement Investors to Avoid Thinking in Lump Sum Terms," (FiduciaryNews.com, July 29, 2014). Written in a way that appears to indict the average Joe, the paper implies people are mathematical disabled. Well, it more than implies it, it shows why they are. Only, instead of saying, "Silly MPT, why expect people to behave rationally when they don't," it suggests, "Silly irrational people, we need to trick them so they don't trick themselves." 

The paper's point shows how people can't tell the difference between two widely used retirement numbers – a lump sum and its equivalently valued monthly payout. It appears to want to explain why people "irrationally" avoid annuities – the "sure thing" monthly payout vs. the "risky" lump sum. It concludes people make the "risky" choice, even though it is the financial equivalent of the "sure thing," because it appears the lump sum is worth more than the monthly payout. It is, after all, a much larger number. 

But that's not all. When offered much large equivalent numbers, people make the opposite choice – they go for the "sure thing" and forsake the "risky" option. You might think, "Well, isn't that the definition of 'irrational'?" No. It turns out it is quite rational. You see, in the small dollar scenario, the monthly payout doesn't cover their monthly expenses. Conversely, in the large dollar scenario, the monthly payout exceeds monthly expenses. 

Makes sense to me. Why would you accept an option that, while less risky from a future value standpoint, guarantees you'll go bankrupt? Who do these researchers think their test subjects are? Politicians? 

The paper, perhaps inadvertently, brilliantly explains why the "annuity puzzle" or the "annuity anomaly" isn't that puzzling and isn't that anomalous at all. It's simply this: people don't want a "sure thing" if it doesn't pay the bills. They'd rather have a risky option that's more than enough for the short term, and gives them (even if small) a chance to get to the point where it can pay their monthly expenses for the rest of their life. 

The average retirement investor may not be as rational as required by MPT, but they aren't that stupid, either.

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Christopher Carosa

Chris Carosa has been writing a weekly article and monthly column for BenefitsPRO online and BenefitsPRO Magazine since 2011 and is a nationally recognized award-winning writer, researcher and speaker. He’s written seven books, including From Cradle to Retire: The Child IRA; Hey! What’s My Number? – How to Increase the Odds You Will Retire in Comfort; A Pizza The Action: Everything I Ever Learned About Business I Learned By Working in a Pizza Stand at the Erie County Fair; and the widely acclaimed 401(k) Fiduciary Solutions. Carosa is also Chief Contributing Editor of the authoritative trade journal FiduciaryNews.com and publisher of the Mendon-Honeoye Falls-Lima Sentinel, a weekly community newspaper he founded in 1989. Currently serving as President of the National Society of Newspaper Columnists and with more than 1,000 articles published in various publications, he appears regularly in the national media. A “parallel” entrepreneur, he actively runs a handful of businesses, including a small boutique investment adviser, providing hands-on experience for his writing. A trained astrophysicist, he also holds an MBA and has been designated a Certified Trust and Financial Advisor. Share your thoughts and story ideas with him through Facebook (https://www.facebook.com/christophercarosa/)and Twitter (https://twitter.com/ChrisCarosa).