Annuitization and asset allocation

Abstract

This paper examines the optimal annuitization, investment and consumption strategies of a utility-maximizing retiree facing a stochastic time of death under a variety of institutional restrictions. We focus on the impact of aging on the optimal purchase of life annuities which form the basis of most Defined Benefit pension plans. Due to adverse selection, acquiring a lifetime payout annuity is an irreversible transaction that creates an incentive to delay. Under the institutional all-or-nothing arrangement where annuitization must take place at one distinct point in time (i.e. retirement), we derive the optimal age at which to annuitize and develop a metric to capture the loss from annuitizing prematurely. In contrast, under an openmarket structure where individuals can annuitize any fraction of their wealth at anytime, we locate a general optimal annuity purchasing policy. In this case, we find that an individual will initially annuitize a lump sum and then buy annuities to keep wealth to one side of a separating ray in wealth-annuity space. We believe our paper is the first to integrate life annuity products into the portfolio choice literature while taking into account realistic institutional restrictions which are unique to the market for mortality-contingent claims. r

Too Risk Averse to Purchase Insurance? A Theoretical Glance at the Annuity Puzzle

“…Milevsky and Young (2007) and Horneff, Maurer, Mitchell and Stamos (2010) prove that a low level of annuitization results from allowing individuals to trade stocks in addition to standard bonds and annuities. They therefore argue that the annuity puzzle stems from the lack of annuities backed by high-risk and high-return assets.…”

Consumer Preferences for Annuity Attributes: Beyond Net Present Value

“…Another disadvantage is a loss of control over the assets because the investment funds are given to the annuity company to manage, which may result in not benefiting from potential returns from stocks and other risky financial products (Milevsky and Young 2007). Issuing companies can vary in financial strength ratings, which is clearly important given the fact that the decision has implications for many years and because government backing for such products is dependent on state-level regulations.…”

The annuity puzzle remains a puzzle

“…2 We assume a fixed retirement age and do not explore optimal annuitization and retirement timing as in Milevsky and Young (2007). where β is the time preference discount factor, γ denotes the level of risk aversion, and C t is the real amount of wealth consumed at the beginning of period t. The probability of surviving to age t, conditional on having lived to period t − 1, is indicated by p t . We denote the nominal consumption as C t = C t Π t , where Π t is the price index at time t.…”