Døskeland, Trond M. () (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration) Nordahl, Helge A. () (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)
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In this paper we analyze how the traditional life and pension contracts with a guaranteed rate of return can be optimized to increase customers’ welfare. Given that the contracts have to be priced correctly, we use individuals’ preferences to find the preferred design. Assuming CRRA utility, we cannot explain the existence of any form of guarantees. Through numerical solutions we quantify the difference (measured in certainty equivalents) to the preferred Merton solution of direct investments in a fixed proportion of risky and risk free assets. The largest welfare loss seems to come from the fact that guarantees are effective by the end of each year, not only by the expiry of the contract. However, the demand for products with guarantees may be explained through behavioral models. We use cumulative prospect theory as an example, showing that the optimal design is a simple contract with a life-time guarantee and no default option.
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Paper provided by Department of Finance and Management Science, Norwegian School of Economics and Business Administration in its series Discussion Papers with number
2006/14.
Length: 22 pages Date of creation: 18 Oct 2006 Date of revision:
21 Jun 2007 Handle: RePEc:hhs:nhhfms:2006_014
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References listed on IDEAS 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.:
John Y. Campbell, 2006.
"Household Finance,"
Journal of Finance,
American Finance Association, vol. 61(4), pages 1553-1604, 08.
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