Variable payout annuities and dynamic portfolio choice in retirement

Abstract

Many retirees hope to continue earning capital market rewards on their saving while avoiding outliving their funds during retirement. We model a dynamic utility maximizing investor who seeks to benefit from holding both equity and longevity insurance. She is free to adjust her portfolio allocation of her financial wealth as well as of the annuity over time, and she can purchase variable payout annuities any time and incrementally. In this setting, we show that the retiree will not fully annuitize even without bequests; rather, she will combine variable annuities with withdrawals from her liquid financial wealth so as to match her desired consumption profile. Optimal stock exposures decrease over time, both within the variable annuity and the withdrawal plan. Welfare gains from this strategy can amount to 40% of financial wealth, depending on risk parameters and other resources; additionally, many retirees will do almost as well as the fully optimized outcome if they hold variable annuities invested 60/40 in stocks/bonds.

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.…”

“…7 See for example Ponzetto (2003), Inkmann, Lopes andMichaelides (2009) andHorneff, Maurer andStamos (2010). 8 Precautionary savings can be defined as the optimal amount of saving due to the uncertainty of the second-period income.…”

What Determines Annuity Demand at Retirement?

“…10 By contrast, there has been a lot of theoretical research to determine optimal annuity demand. For instance: Ameriks et al (2011), Horneff et al (2009Horneff et al ( , 2010, Butler et al (2011). 11 Surveys of the development of annuity markets around the world can be found in James and Song (2002), Mackenzie (2006), and Cannon and Tonks (2008).…”

Should Households Base Asset Decumulation Strategies on Required Minimum Distribution Tables?

“…We report selected results in Tables A1, A2 and A3. Variable payout immediate annuities offer households the benefits of both longevity insurance and the equity premium and are, in theory, attractive (Horneff et al, 2010). But sales have been even more limited than those of fixed immediate annuities, and we therefore exclude them from our analysis.…”

“…But their effect on optimal consumption is unclear as the marginal utility of non-health consumption may vary with health status. 9 Brown and Poterba (2000); Horneff et al (2008Horneff et al ( , 2010. 10 An alternative would be to assume that basic living expenses, possibly an amount equal to Social Security benefits, did not contribute to utility.…”