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On the sub-optimality cost of immediate annuitization in DC pension funds

Author

Listed:
  • Marina Di Giacinto
  • Elena Vigna

Abstract

We consider the position of a member of a defined contribution (DC) pension scheme having the possibility of taking programmed withdrawals at retirement. According to this option, she can defer annuitization of her fund to a propitious future time, that can be found to be optimal according to some criteria. This option, that adds remarkable flexibility in the choice of pension benefits, is not available in many countries, where immediate annuitization is compulsory at retirement. In this paper, we address and try to answer the questions: "Is immediate annuitization optimal? If it is not, what is the cost to be paid by the retiree obliged to annuitize at retirement?". In order to do this, we consider the model by [7] and extend it in two different ways. In the first extension, we prove a theorem that provides necessary and sufficient conditions for immediate annuitization being always optimal. The – not surprising – result is that compulsory immediate annuitization turns out to be sub-optimal. We then quantify the extent of sub-optimality, by defining the sub-optimality cost as the loss of expected present value of consumption from retirement to death and measuring it in many typical situations. We find that it varies in relative terms between 6% and 40%, depending on the risk aversion. In the second extension, we make extensive numerical investigations of the model and seek the optimal annuitization time. We find that the optimal annuitization time depends on personal factors such as the retiree's risk aversion and her subjective perception of remaining lifetime. It also depends on the financial market, via the Sharpe ratio of the risky asset. Optimal annuitization should occur a few years after retirement with high risk aversion, low Sharpe ratio and/or short remaining lifetime, and many years after retirement with low risk aversion, high Sharpe ratio and/or long remaining lifetime. This paper supports the availability of programmed withdrawals as an option to retirees of DC pension schemes, by giving an idea about the extent of loss in wealth suffered by a retiree who cannot choose programmed withdrawals, but is obliged to annuitize immediately on retirement.

Suggested Citation

  • Marina Di Giacinto & Elena Vigna, 2010. "On the sub-optimality cost of immediate annuitization in DC pension funds," Carlo Alberto Notebooks 188, Collegio Carlo Alberto.
  • Handle: RePEc:cca:wpaper:188
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    File URL: http://www.carloalberto.org/assets/working-papers/no.188.pdf
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    Keywords

    Defined contribution pension scheme; decumulation phase; optimal annuitization time; cost of sub-optimality;

    JEL classification:

    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • J26 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Retirement; Retirement Policies

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