Regret aversion and annuity risk in defined contribution pension plans
AbstractThe high value of the implicit option to choose a retirement date at which interest rates are particularly high and life annuities relatively cheap, leads to the possibility to introduce regret aversion in the retirement investment decision of defined contribution plan participants. As a remedy for regret aversion in retirement investment decisions, this paper develops and prices a lookback option on a life annuity contract. We determine a closed-form option value under the restriction that the option holder invests risklessly during the time to maturity of the option and without the guarantee that the exact amount of retirement wealth is converted into a life annuity at retirement. Thereafter the investment restriction is relaxed and the guarantee of exact conversion is imposed and the option is priced via Monte Carlo simulations in an economic environment with a stochastic discount factor. Option price sensitivities are determined via the pricing of alternative options. We find that the price of a lookback option, with a maturity of three years, amounts to 8%-9% of the wealth at the option issuance date. The option price is highly sensitive to the exercise price of the option, i.e.Ã pricing alternative options (e.g.Ã Asian) substantially lowers the price. Time to maturity and interest rate volatility are other important option price drivers. Asset allocation decisions and initial interest rates hardly affect the option price.
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Bibliographic InfoPaper provided by Maastricht University in its series Open Access publications from Maastricht University with number urn:nbn:nl:ui:27-22861.
Date of creation: 2008
Date of revision:
Publication status: Published in Insurance (2008) v.42, p.1050-1061
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Other versions of this item:
- Frehen, Rik G.P. & Hoevenaars, Roy P.M.M. & Palm, Franz C. & Schotman, Peter C., 2008. "Regret aversion and annuity risk in defined contribution pension plans," Insurance: Mathematics and Economics, Elsevier, vol. 42(3), pages 1050-1061, June.
- C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
- G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
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