Ian answers: Robert, my answer to your question taps into the interesting space of financial decision making – and some of the factors involved that are not to do with price. This includes our tendency to want to avoid making a loss on financial decisions, the appeal of “free” and the fact that we don’t always behave in a way that is rational.
In your longer question you described people commonly buying an insurance product that requires paying a premium each month for many years – it can be thought of as a type of endowment policy. Under this arrangement, a guaranteed sum is typically paid out at maturity (a pre-agreed date) or earlier if the policyholder or partner dies. The cover might be used to ensure a mortgage or other loan is paid off even if the borrower passes away.
However, you note there is a cheaper alternative: life insurance to cover the event of death over the same period. The difference in premiums between the life insurance and the endowment policies could be invested, possibly producing a bigger return. You ask why the endowment policies are popular and why do many people make the apparently irrational choice to get them?
Leaving aside any tax related issues – which could substantially alter the sums involved – I think the reason people commonly choose the more expensive option is because they are not making the decision primarily on price.
We don’t like complexity
The first thing is that comparing the alternatives is complex – just look at the amount of space it took to describe the scenario. Without clear guidance, I am confident only a few people would understand the relative costs. Financial literacy in the general population is low in all countries. For example, studies have shown that only about 20% of people know that bond prices fall when interest rates rise. I think understanding how bonds work is easier than understanding the relative value of the two products you described.
Further, even if a salesperson took the time to outline the relative cost of the alternatives, I suspect few would pay attention long enough to fully understand. Inattention is known to be a major problem in getting people to understand various issues, not only related to money.
Even assuming the relative cost of the alternatives were understood by the customer, the first may still be chosen because many people place a high value on the guaranteed payment.
We like things we get for free
People like being given something that they don’t pay for – or more correctly that they do not know that they are paying for. BOGOF (buy one get one free) offers are common when shopping for everyday items because they play to the psychology that you are you are getting something for free. The trouble is that you may not need an extra pair of socks. Still the temptation is to buy. I suspect that, to some people, the guarantee for being paid a set amount some time in the future, in addition to the life insurance, is simplified to being something similar to getting something for free.
We really loathe making a loss
Further the guarantee plays on one of the most important emotions affecting decisions people make about money – loss aversion. People don’t like losing money. Studies commonly suggest that the feelings of pain associated with losing money are more than twice the feelings of pleasure felt from gaining the same amount.
An important difference between the endowment insurance and the alternative is that the second carries the potential of a loss. Even though this potential is small, it is known that people commonly overweight the possibilities associated with small probabilities.
We like making a commitment
A further difference between the products that price alone does not reveal is that the endowment option forces the buyer to make a commitment for a long time. The alternative requires the buyer to have the discipline to make investments as well as life insurance payments on a regular basis. The first approach is difficult to get out of. The second can be broken easily.
We’re not necessarily rational
Many other things could influence the decisions people make when choosing between these financial products. One thing is certain. Price is not the only factor.
So while a cool headed financial analysis may find that the decisions many people make are irrational, the extra cost might be worth it to buyer.