Bryan Caplan  

Bequest Question

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According to "mistake" theories of inheritance, people leave bequests because they don't have enough information to spend all their assets before they die.

Question: In a world with annuities and negative mortgages, how can anyone continue to believe this story?

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COMMENTS (15 to date)
Chris writes:

Not familiar with the 'mistake' theories. Have a paper in mind? Care to point us in the right direction?

Kevin writes:

Bryan, one story I have heard is that the elderly keep their money around in order to retain leverage over their children.

Steve Sailer writes:

Freddie Mercury supposedly spent every penny of the $42 million he'd earned by the day of his death.

Phil writes:

Couldn't the "mistake" theory be at least part of it?

Annuities are taxed more harshly than income from equities (including capital gains). Annuities involve high costs (security is expensive). Annuities have low inflation-adjusted rates of return compared to other investments.

That's why I haven't bought an annuity. If tomorrow I find out I have one year to live, I probably won't be able to spend all my savings. That qualifies as a "mistake," doesn't it?

I can guarantee you that if I were to know my date of death, I would have less money at death than if I didn't know my date of death. Guaranteed.

ateamrules writes:

Even though I don't put much stock in the "mistake" theory, I don't think your examples do much to counter it. While an annuity could allow someone to guarantee that they spend down all of their assets by death, the purchase of the annuity doesn't make retirement riskless. The rigidity of annuity cashflows are really only suitable for insuring predictable expenses. Most people will want free cash besides the annuity to pay for surprise necessities (maybe a better nursing home than Medicaid will pay for) or spur of the moment splurges.

Bill writes:

I have no clue as to truth, but some economists I have asked about it claim that that annuity markets are afflicted with adverse selection and that returns are therefore very low (Stiglitz was fond of this assertion when I took macro from him, for example). Certainly, you have to believe some story of market failure in annuities or irrationality by consumers to make the mistake theory work.

Dr. T writes:

Whoever conceived the "mistake" theory hasn't talked with old folks. Many of them have good information about how long they'll live and how much money they could spend. However, the majority of them don't plan expensive world cruises. They plan to bequest their money to people, causes, or things that they love. They don't give everything away while alive in case they unexpectedly need lots of money. This aspect of personal financial planning is handled more logically than most other aspects.

Phil writes:

I don't see how to solve the problem, even with an annuity. Suppose I want $X a year for normal expenses, but every so often I find a luxury that costs $Y that I want. Also, every year there's a certain probability that I might find a new hobby, on which I will spend an extra $Z a year in perpetuity.

Assume my current wealth is exactly the amount that lets me afford all three of these factors (on an expected value basis).

Assume also that I'm perfectly rational, and prefer to leave a bequest of $0.

How do I arrange this? I don't think I can.

MikeP writes:

One instrument that would do all that Phil is looking for is the following:

1. Give all your assets to the bank. They manage them as an account.

2. They determine actuarily that they can give you $X per month, inflation adjusted, for the rest of your life and make a nominal profit. Each month X may go up or down as your account goes up or down.

3. At any time, you can draw more money out of the account. That of course changes X. You never take out so much that X goes below some desired Y.

I would say that even with such a perfectly designed zeroing out of ones assets for maximum end of life consumption, you still won't spend your $X per month. You simply run out of marginally interesting things to spend it on. I expect older people with less mobility and more grandchildren run out even faster than the average person. You'll have another account the $X goes into that you pay the bills out of. That account won't end up being zero on the first day of the next month.

MikeP writes:

To clarify, the monthly recomputation is not done actuarially every month. When you start the annuity, they look at their tables and give you a percentage P you get every month. That fixed percentage of the account's original principal plus whatever new principal you add and minus whatever principal you withdraw, all inflation adjusted, is what you get every month from then on.

Presumably the bank keeps the gains and losses from the account as an investment since they are managing that aspect.

Yeah, I don't understand you're reasoning on this, Byran. Financial tools like annuities and negative mortgages are helpful precisely to the extent that you do have good information about how much money you'll want to spend between now and dying.

Given a probability distribution of how much money you'll want to spend while living, you could decide to immediately give away all of your money except what you need to cover X% of that distribution (and make appropriate arrangements with annuities, etc.). The question is, how to choose X? To answer that, one has to balance the chance of needing to spend an amount of money in excess of the X-th percentile against the chance that whatever amount of money you bequeath might not be spent as you intended.

Eric Johnson writes:

This is easily explained by evo psych. Most people know Hamilton's rule: that you would (theoretically) accept a 0.499 chance of death to save your brother from certain death. Or face a 0.1249999 risk of death, in order to save your cousin from certain death. Its because the alleles that would direct you to this, have a 0.5 chance of saving a copy of those same alleles in your brother; hence such alleles can rise in frequency.

But theres more to it than that. As you age, your future reproductive potential goes very low. The young are more valuable than the old in the fitness calculus. The behavior that would be selected is to scrimp and save til the end, and donate your wealth to younger blood relatives.

Ryan Vann writes:

Mr. Johnson,

Great post. It's always good to bring other sciences into economic discussion.

Anyway, I think I see Mr. Caplan's point. With both annuities (unless you have survivorship clauses, which also provide a case against "mistake" theory) and reverse mortgages becomes zero asset value items upon your death.

I'm not sure this zeroing out necessarily answers the problem raised by the mistake theory. However, I do think survivorship clauses do some pretty sizeable damage to the notion that inheritances are just financial planning overages. I'll add more clarification about survivorship later.

Kurt writes:

I'd say that a lot of folks will continue to accumulate wealth to death almost as habit. As you approach old age, your desire to spend will decrease. You're health is failing, you are getting at senality. You don't WANT a cruise. You want to watch Matlock, in your nursing care room... which is cheap, aside from the care itself. Your obsession with your own mortality will steer many people away from profligate spending. If you've been miserly enough in your life to accumulate mass wealth, it's more then likely that this is due to habit and disposition , a disposition you are not likely to betray at death. The wealthy are good at staying wealthy, through thick and thin.

Levi writes:
Kevin: Bryan, one story I have heard is that the elderly keep their money around in order to retain leverage over their children.
Bernheim, B.D, Shleifer, A. & Summers, L.H. (1985). The Strategic Bequest Motive. Journal of Political Economy, 93, 1045-1076.

Good ol' Larry Summers.

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