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Optimal Gradual Annuitization: Quantifying the Costs of Switching to Annuities

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  • Wolfram J. Horneff
  • Raimond H. Maurer
  • Michael Z. Stamos
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    Abstract

    We compute the optimal dynamic annuitization and asset allocation policy for a retiree with Epstein-Zin preferences, uncertain investment horizon, potential bequest motives, and pre-existing pension income. In our setting the retiree can decide each year how much he consumes and how much he invests in stocks, bonds, and life annuities, while the prior literature mostly considered restricted so-called deterministic or stochastic switching strategies. We show that postponing the annuity purchase is no longer optimal in the gradual annuitization (GA) case since investors are able to attain the optimal mix between liquid assets (stocks and bonds) and illiquid life annuities each year. In order to assess potential utility losses, we benchmark various restricted annuitization strategies against the unrestricted GA strategy. Copyright (c) The Journal of Risk and Insurance, 2008.

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    Bibliographic Info

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

    Volume (Year): 75 (2008)
    Issue (Month): 4 ()
    Pages: 1019-1038

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    Handle: RePEc:bla:jrinsu:v:75:y:2008:i:4:p:1019-1038

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    1. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
    2. Gomes, Francisco J & Michaelides, Alexander, 2005. "Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence," CEPR Discussion Papers 4853, C.E.P.R. Discussion Papers.
    3. Geoffrey Kingston & Susan Thorp, 2004. "Annuitization and Asset Allocation with HARA Utlity," Econometric Society 2004 Australasian Meetings 248, Econometric Society.
    4. Milevsky, Moshe A. & Young, Virginia R., 2007. "Annuitization and asset allocation," Journal of Economic Dynamics and Control, Elsevier, vol. 31(9), pages 3138-3177, September.
    5. 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.
    6. Joao F. Cocco, 2005. "Consumption and Portfolio Choice over the Life Cycle," Review of Financial Studies, Society for Financial Studies, vol. 18(2), pages 491-533.
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    Cited by:
    1. 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.
    2. Sanders, E.A.T. & De Waegenaere, A.M.B. & Nijman, T.E., 2010. "When Can Insurers Offer Products That Dominate Delayed Old-Age Pension Benefit Claiming?," Discussion Paper 2010-43, Tilburg University, Center for Economic Research.
    3. Blake, David & Wright, Douglas & Zhang, Yumeng, 2014. "Age-dependent investing: Optimal funding and investment strategies in defined contribution pension plans when members are rational life cycle financial planners," Journal of Economic Dynamics and Control, Elsevier, vol. 38(C), pages 105-124.
    4. Hans Fehr, 2009. "Computable Stochastic Equilibrium Models and Their Use in Pension- and Ageing Research," De Economist, Springer, vol. 157(4), pages 359-416, December.
    5. Blake, David & Boardman, Tom, 2010. "Spend more today: Using behavioural economics to improve retirement expenditure decisions," MPRA Paper 34234, University Library of Munich, Germany.
    6. Thomas Post, 2009. "Individual Welfare Gains from Deferred Life-Annuities under Stochastic Lee-Carter Mortality," SFB 649 Discussion Papers SFB649DP2009-022, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.

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