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Asset Allocation and the Liquidity Premium for Illiquid Annuities

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  • S. Browne
  • M. A. Milevsky
  • T. S. Salisbury
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    Abstract

    Academics and practitioners alike have developed numerous techniques for benchmarking investment returns to properly adjust seemingly high numbers for excessive levels of risk. The same, however, cannot be said for liquidity, or the lack thereof. This article develops a model for analyzing the "ex ante" liquidity premium demanded by the holder of an illiquid annuity. The annuity is an insurance product that is akin to a pension savings account with both an accumulation and decumulation phase. We compute the yield (spread) needed to compensate for the utility welfare loss, which is induced by the inability to rebalance and maintain an optimal portfolio when holding an annuity. Our analysis goes beyond the current literature, by focusing on the interaction between time horizon (both deterministic and stochastic), risk aversion, and preexisting portfolio holdings. More specifically, we derive a negative relationship between a greater level of individual risk aversion and the demanded liquidity premium. We also confirm that, "ceteris paribus", the required liquidity premium is an increasing function of the holding period restriction, the subjective return from the market, and is quite sensitive to the individual's endowed (preexisting) portfolio. Copyright The Journal of Risk and Insurance.

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    Bibliographic Info

    Article provided by The American Risk and Insurance Association in its journal The Journal of Risk and Insurance.

    Volume (Year): 70 (2003)
    Issue (Month): 3 ()
    Pages: 509-526

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    Handle: RePEc:bla:jrinsu:v:70:y:2003:i:3:p:509-526

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    Cited by:
    1. Horneff, Wolfram J. & Maurer, Raimond H. & Mitchell, Olivia S. & Dus, Ivica, 2008. "Following the rules: Integrating asset allocation and annuitization in retirement portfolios," Insurance: Mathematics and Economics, Elsevier, vol. 42(1), pages 396-408, February.
    2. Wolfram J. Horneff & Raimond H. Maurer & Olivia S. Mitchell & Michael Z. Stamos, 2007. "Money in Motion: Dynamic Portfolio Choice in Retirement," NBER Working Papers 12942, National Bureau of Economic Research, Inc.
    3. Wolfram J. Horneff & Raimond H. Maurer & Olivia S. Mitchel & Michael Z. Stamos, 2008. "Asset Allocation and Location over the Life Cycle with Survival-Contingent Payouts," Working Papers wp177, University of Michigan, Michigan Retirement Research Center.
    4. Horneff, Wolfram J. & Maurer, Raimond H. & Mitchell, Olivia S. & Stamos, Michael Z., 2010. "Variable payout annuities and dynamic portfolio choice in retirement," Journal of Pension Economics and Finance, Cambridge University Press, vol. 9(02), pages 163-183, April.
    5. Wolfram J. Horneff & Raimond H. Maurer & Olivia S. Mitchell & Michael Z. Stamos, 2008. "Asset Allocation and Location over the Life Cycle with Survival-Contingent Payouts," NBER Working Papers 14055, National Bureau of Economic Research, Inc.
    6. Byoung-Min Kim & Richard Widdows & Tansel Yilmazer, 2005. "The determinants of consumers’ adoption of Internet banking," Conference Series ; [Proceedings], Federal Reserve Bank of Boston.

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