Insuring longevity risk while having multiple savings accounts

by Abigail Hurwitz & Orly Sade
Posted on July 08, 2020

Imagine that you just retired, and you need to decide how to withdraw your savings. How much of it will you invest in an annuity (i.e. a sum of money, typically paid every month of the year for the rest of your life) and how much will you cash out as a lump sum (a single payment made upon retirement)? You must avoid to exhaust your assets too quickly, but you need enough money to face potential liquidity shocks in the future. There are so many aspects to consider...

This intricate decision is most often made by older individuals, and can have significant consequences on their well-being. Given its complexity and importance, there is growing academic and practical interest aimed at enhancing both long-term savings and demand for longevity insurance products.

Imagine now that you saved for retirement via different products or pension funds, like most people do (as a result of job changes throughout the years). Will the distribution of your funds according to the size of the accounts affect your withdrawal decisions? If you are rational, you will probably allocate your accumulated savings between an annuity and a lump sum, regardless of the size or distribution of the different accounts.

Data from Israel

There is relatively little empirical evidence on how multiple accounts influence the decision to withdraw funds upon retirement. Our research investigates empirically and experimentally if the distribution of pension savings across various providers, and the relative size of each specific savings account, affects individuals’ decision to either annuitize or cash out their saving accounts at retirement.

For our research, we rely on a very detailed proprietary data set from a leading insurance company in Israel. It includes information regarding the annuitization decisions of retirees, and a rich set of parameters that describes these individuals (from 2009 until 2013). We document a correlation between the size of the accumulated funds and the decision to annuitize. We also noticed that retirees with small accounts were significantly more likely to cash out all their savings upon retirement.

The fact that annuitization rates differ with account size is indeed puzzling. It can be related to the possibility of having multiple savings accounts. We further studied this phenomenon by conducting three more experiments: an online survey, an incentivized experiment in the laboratory, and an experimental survey of financial experts.

“The larger the accumulated funds in the pension account, the more likely people are to annuitize upon retirement.”

Three diverse experiments

In our online survey, conducted in 2018 and 2019, participants were asked to divide a total sum of retirement money between an annuity and a lump sum. A total of 1,971 participants - from a representative sample of the Israeli population - were randomly assigned to one of five conditions, with different distributions of the virtual savings amount (everyone had either one or two savings accounts).

Regardless of the division of funds throughout the accounts, our results suggest that the mean proportion of funds withdrawn as a lump sum from the account with the larger amount out of the two is about one third. This implies a preference for the annuity option - a result that is consistent with the actual annuity take-up rates in Israel (which we researched in our 2019 study). However, the small accounts were significantly more likely to be withdrawn as a lump sum. And the smaller the amount, the more likely it was to be cashed out.

These findings suggest that the composition of the accounts do indeed matter. The effect that the distribution of funds across accounts has on the decision to annuitize, derives from differences in the tails of the distribution.

Conclusions and implications

Given the global dynamic job market and high unemployment rates due to the current COVID-19 outbreak, individuals are expected to change jobs, and in turn, hold several savings accounts. This will have important implications on the decisions that individuals will make about their pension savings.

We document a significant and positive effect of the size of the accumulated funds on the decision to annuitize. The larger the accumulated sum of money in the pension account, the higher the propensity to annuitize upon retirement. In a further set of experiments, we also provide evidence that the very existence of a small account within a portfolio may in fact alter annuitization rates related to that total amount. In other words, we show that diversification across accounts may lead to different decisions and result in different financial outcomes for both individuals and financial institutions.

In the upcoming months, we will study the consequences and implications of first presenting retirees with their total accumulation and discussing the various needs upon retirement before they make the annuitization decisions.

Abigail Hurwitz is lecturer at Hebrew University of Jerusalem and College of Management Academic Studies, Israel.

Orly Sade is Associate Professor of Finance at Hebrew University of Jerusalem.