Efficient Annuitization with Delayed Payout Annuities
49 Pages Posted: 25 Sep 2006
Date Written: November 2006
Contrary to economic theory, few retirees voluntarily annuitize much, if any, of their wealth. This behavior has been at least partly explained by factors such as bequest motives, a demand for liquid wealth, or a restrictive annuity investment universe, all of which impose implicit costs on annuitization. When such costs are considered, utility maximization implies a preference for annuity contracts that are efficient in the sense that they deliver maximum benefit for a given annuity investment. In a standard lifecycle setting, we find that efficient annuity allocations involve no annuity payouts in early years, while later years are fully funded by annuities. Importantly, insurance companies have recently introduced annuity contracts with payouts that begin in the future, referred to as delayed payout annuities. We find that delayed payout annuities are highly efficient. For a typical example, half the potential annuity welfare gains require only a six percent allocation to delayed payout annuities compared to a thirty-nine percent allocation to immediate annuities. Because of their efficiency, delayed payout annuities can substantially improve welfare, particularly for retirees unwilling to annuitize large fractions of their wealth.
Keywords: Annuities, annuitization, Social Security, pensions, longevity risk, insurance
JEL Classification: D11, D91, E21, H55, J14, J26
Suggested Citation: Suggested Citation