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Capital Accumulation and Uncertain Lifetimes with Adverse Selection

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  • Abel, Andrew B

Abstract

This paper examines the implications of adverse selection in the private annuity market for the pricing of private annuities and the consequent effects on constrption and bequest behavior. With privately known heterogeneous mortality probabilities, adverse selection causes the rate of return on private annuities to be less than the actuarially fair rate based on population average mortality. However, a fully funded social security system with compulsory participation can offer an implied rate of return equal to the actuarially fair rate based on population average mortality. Thus, since social security offers a higher rate of return than private annuities, consumers cannot completely offset the effects of social security by transacting in the private annuity market. Using an overlapping generations model with uncertain lifetimes, we demonstrate that the introduction of actuarially fair social security reduces the steady state rate of return on annuities and raises the steady state levels of average bequests and average consumption of the young. The steady state national capital stock rises or falls according to the strength of the bequest motive.

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Article provided by Econometric Society in its journal Econometrica.

Volume (Year): 54 (1986)
Issue (Month): 5 (September)
Pages: 1079-97

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Handle: RePEc:ecm:emetrp:v:54:y:1986:i:5:p:1079-97

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  1. Fischer, Stanley, 1973. "A Life Cycle Model of Life Insurance Purchases," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 14(1), pages 132-52, February.
  2. Levhari, David & Mirman, Leonard J, 1977. "Savings and Consumption with an Uncertain Horizon," Journal of Political Economy, University of Chicago Press, vol. 85(2), pages 265-81, April.
  3. Laurence J. Kotlikoff & Avia Spivak, 1979. "The Family as an Incomplete Annuities Market," UCLA Economics Working Papers 151, UCLA Department of Economics.
  4. Barro, Robert J & Friedman, James W, 1977. "On Uncertain Lifetimes," Journal of Political Economy, University of Chicago Press, vol. 85(4), pages 843-49, August.
  5. Barro, Robert J., 1974. "Are Government Bonds Net Wealth?," Scholarly Articles 3451399, Harvard University Department of Economics.
  6. Sheshinski, Eytan & Weiss, Yoram, 1981. "Uncertainty and Optimal Social Security Systems," The Quarterly Journal of Economics, MIT Press, vol. 96(2), pages 189-206, May.
  7. Eckstein, Zvi & Eichenbaum, Martin S & Peled, Dan, 1985. "The Distribution of Wealth and Welfare in the Presence of Incomplete Annuity Markets," The Quarterly Journal of Economics, MIT Press, vol. 100(3), pages 789-806, August.
  8. Abel, Andrew B, 1985. "Precautionary Saving and Accidental Bequests," American Economic Review, American Economic Association, vol. 75(4), pages 777-91, September.
  9. Rothschild, Michael & Stiglitz, Joseph E, 1976. "Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information," The Quarterly Journal of Economics, MIT Press, vol. 90(4), pages 630-49, November.
  10. Paul A. Samuelson, 1958. "An Exact Consumption-Loan Model of Interest with or without the Social Contrivance of Money," Journal of Political Economy, University of Chicago Press, vol. 66, pages 467.
  11. Richard, Scott F., 1975. "Optimal consumption, portfolio and life insurance rules for an uncertain lived individual in a continuous time model," Journal of Financial Economics, Elsevier, vol. 2(2), pages 187-203, June.
  12. Drazen, Allan, 1978. "Government Debt, Human Capital, and Bequests in a Life-Cycle Model," Journal of Political Economy, University of Chicago Press, vol. 86(3), pages 505-16, June.
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