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Optimal portfolio choice with annuitization

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Author Info
Koijen, Ralph S.J.
Nijman, Theo E.
Werker, Bas J.M. (Tilburg University, Center for Economic Research)

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Abstract

We study the optimal consumption and portfolio choice problem over an individual's life-cycle taking into account annuity risk at retirement. Optimally, the investor allocates wealth at retirement to nominal, inflation-linked, and variable annuities and conditions this choice on the state of the economy. We also consider the case in which there are, either for behavioral or institutional reasons, limitations in the types of annuities that are available at retirement. Subsequently, we determine how the investor optimally anticipates annuitization before retirement. We find that i) using information on term structure variables and risk premia significantly improves the optimal annuity choice, ii) restricting the annuity menu to nominal or inflation-linked annuities is costly for both conservative and more aggressive investors, and iii) adjustments in the optimal investment strategy before retirement induced by the annuity demand due to inflation risk and time-varying risk premia are economically significant. This holds as well for sub-optimal annuity choices. The adjustment to hedge real interest rate risk is negligible. We estimate that the welfare costs of not taking these three factors into account at retirement are 9% for an individual with an average risk aversion ( = 5). Not hedging annuity risk before retirement causes an additional welfare costs between 1% and 13%, depending on the annuitization strategy implemented at retirement.

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Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 78.

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Date of creation: 2006
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Handle: RePEc:dgr:kubcen:200678

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Find related papers by JEL classification:
D91 - Microeconomics - - Intertemporal Choice and Growth - - - Intertemporal Consumer Choice; Life Cycle Models and Saving
G0 - Financial Economics - - General
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G23 - Financial Economics - - Financial Institutions and Services - - - Pension Funds; Other Private Financial Institutions

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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Wolfram Horneff & Raimond Maurer & Olivia Mitchell & Michael Stamos, 2007. "Money in Motion: Dynamic Portfolio Choice in Retirement," Working Papers wp152, University of Michigan, Michigan Retirement Research Center. [Downloadable!]
    Other versions:
  2. 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. [Downloadable!] (restricted)
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