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Optimizing the Retirement Portfolio: Asset Allocation, Annuitization, and Risk Aversion

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  • Wolfram J. Horneff
  • Raimond Maurer
  • Olivia S. Mitchell
  • Ivica Dus

Abstract

Retirees must draw down their accumulated assets in an orderly fashion so as not to exhaust their funds too soon. We derive the optimal retirement portfolio from a menu that includes payout annuities as well as an investment allocation and a withdrawal strategy, assuming risk aversion, stochastic capital markets, and uncertain lifetimes. The resulting portfolio allocation, when fixed as of retirement, is then compared to phased withdrawal strategies such a %u201Cself-annuitization%u201D plan or the 401(k) %u201Cdefault%u201D pattern encouraged under US tax law. Surprisingly, the fixed percentage approach proves appealing for retirees across a wide range of risk preferences, supporting financial planning advisors who often recommend this rule. We then permit the retiree to switch to an annuity later, which gives her the chance to invest in the capital market and %u201Cbet on death.%u201D As risk aversion rises, annuities first crowd out bonds in retiree portfolios; at higher risk aversion still, annuities replace equities in the portfolio. Making annuitization compulsory can also lead to substantial utility losses for less risk-averse investors.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12392.

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Date of creation: Jul 2006
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Handle: RePEc:nbr:nberwo:12392

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  1. Thomas Davidoff & Jeffrey R. Brown & Peter A. Diamond, 2003. "Annuities and Individual Welfare," NBER Working Papers 9714, National Bureau of Economic Research, Inc.
  2. R. C. Merton, 1970. "Optimum Consumption and Portfolio Rules in a Continuous-time Model," Working papers, Massachusetts Institute of Technology (MIT), Department of Economics 58, Massachusetts Institute of Technology (MIT), Department of Economics.
  3. Albrecht, Peter & Maurer, Raimond, 2001. "Self-Annuitization, Ruin Risk in Retirement and Asset Allocation: The Annuity Benchmark," Sonderforschungsbereich 504 Publications, Sonderforschungsbereich 504, Universität Mannheim;Sonderforschungsbereich 504, University of Mannheim 01-35, Sonderforschungsbereich 504, Universität Mannheim;Sonderforschungsbereich 504, University of Mannheim.
  4. John F. Cogan & Olivia S. Mitchell, 2003. "Perspectives from the President's Commission on Social Security Reform," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 17(2), pages 149-172, Spring.
  5. Ivica Dus & Raimond Maurer & Olivia S. Mitchell, 2005. "Betting on Death and Capital Markets in Retirement: A Shortfall Risk Analysis of Life Annuities," NBER Working Papers 11271, National Bureau of Economic Research, Inc.
  6. Dushi, Irena & Webb, Anthony, 2004. "Household annuitization decisions: simulations and empirical analyses," Journal of Pension Economics and Finance, Cambridge University Press, Cambridge University Press, vol. 3(02), pages 109-143, July.
  7. Kingston, Geoffrey & Thorp, Susan, 2005. "Annuitization and asset allocation with HARA utility," Journal of Pension Economics and Finance, Cambridge University Press, Cambridge University Press, vol. 4(03), pages 225-248, November.
  8. Robert C. Merton, 1982. "On Consumption-Indexed Public Pension Plans," NBER Working Papers 0910, National Bureau of Economic Research, Inc.
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  12. Milevsky, Moshe Arye & Ho, Kwok & Robinson, Chris, 1997. " Asset Allocation via the Conditional First Exit Time or How to Avoid Outliving Your Money," Review of Quantitative Finance and Accounting, Springer, Springer, vol. 9(1), pages 53-70, July.
  13. Jeffrey R. Brown & James M. Poterba, 1999. "Joint Life Annuities and Annuity Demand by Married Couples," NBER Working Papers 7199, National Bureau of Economic Research, Inc.
  14. Ivica Dus & Raimond Maurer & Olivia S. Mitchell, 2003. "Betting on Death and Capital Markets in Retirement: A Shortfall Risk Analysis of Life Annuities versus Phased Withdrawal Plans," Working Papers, University of Michigan, Michigan Retirement Research Center wp063, University of Michigan, Michigan Retirement Research Center.
  15. Brugiavini, Agar, 1993. "Uncertainty resolution and the timing of annuity purchases," Journal of Public Economics, Elsevier, Elsevier, vol. 50(1), pages 31-62, January.
  16. Martin Feldstein & Elena Ranguelova & Andrew Samwick, 1999. "The Transition to Investment-Based Social Security when Portfolio Returns and Capital Profitability are Uncertain," NBER Working Papers 7016, National Bureau of Economic Research, Inc.
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  19. Olivia S. Mitchell & James M. Poterba & Mark J. Warshawsky, 1997. "New Evidence on the Money's Worth of Individual Annuities," NBER Working Papers 6002, National Bureau of Economic Research, Inc.
  20. Joao F. Cocco, 2005. "Consumption and Portfolio Choice over the Life Cycle," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 18(2), pages 491-533.
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Cited by:
  1. Wei Sun & Robert K. Triest & Anthony Webb, 2007. "Optimal retirement asset decumulation strategies: the impact of housing wealth," Public Policy Discussion Paper, Federal Reserve Bank of Boston 07-2, Federal Reserve Bank of Boston.
  2. Ferro, Gustavo, 2008. "On annuities: an overview of the issues," MPRA Paper 20209, University Library of Munich, Germany, revised Oct 2009.
  3. Wolfram Horneff & Raimond Maurer & Olivia Mitchell & Michael Stamos, 2007. "Money in Motion: Dynamic Portfolio Choice in Retirement," Working Papers, University of Michigan, Michigan Retirement Research Center wp152, University of Michigan, Michigan Retirement Research Center.
  4. Olivia S Mitchell & John Piggott & Michael Sherris & Shaun Yow, 2006. "Financial Innovation for an Ageing World," RBA Annual Conference Volume, Reserve Bank of Australia, in: Christopher Kent & Anna Park & Daniel Rees (ed.), Demography and Financial Markets Reserve Bank of Australia.
  5. Gaobo Pang, Mark J. Warshawsk, . "Optimizing the Equity-Bond-Annuity Portfolio in Retirement: The Impact of Uncertain Health Expenses," Research Reports, Watson Wyatt Worldwide 4, Watson Wyatt Worldwide.
  6. Bilias, Yannis & Georgarakos, Dimitris & Haliassos, Michalis, 2009. "Portfolio Inertia and Stock Market Fluctuations," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7239, C.E.P.R. Discussion Papers.
  7. Ferro, Gustavo, 2008. "Un impulso al mercado de rentas vitalicias en España
    [Promoting the annuities market in Spain]
    ," MPRA Paper 20211, University Library of Munich, Germany, revised Jul 2008.

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