Abstract
AbstractThe “annuity puzzle” refers to the fact that annuities are rarely purchased despite the longevity insurance they provide. Most explanations for this puzzle assume that individuals have accurate expectations about their future survival. We provide evidence that individuals misperceive their mortality risk and study the demand for annuities in a setting where annuities are priced by insurers on the basis of objectively-measured survival probabilities but in which individuals make purchasing decisions based on their own subjective survival probabilities. Subjective expectations have the capacity to explain significant rates of nonannuitization, yielding a quantitatively important explanation for the annuity puzzle.
Highlights
Annuities insure individuals against longevity risk by allowing them to exchange wealth for an income stream guaranteed until death
Consistent with an established literature (see, for example, Hurd and McGarry (1995); Elder (2013), Wu et al (2015)), our study finds that, on average, individuals under estimate their probability of survival through their 50s, 60s and 70s and over -estimate their chances of survival through their late 80s and beyond
We illustrate the impact of subjective survival expectations by comparing the mean rate of annuitization in the case where individuals behave according to the scaled life table survival curve for their age, sex and cohort with the case where they behave according to their own subjective survival curve
Summary
Annuities insure individuals against longevity risk by allowing them to exchange wealth for an income stream guaranteed until death. To benchmark the quantitative importance of this channel, we compare these results to those we obtain by introducing into our model actuarially unfair pricing caused by adverse selection (or transaction costs or other market imperfections), a leading rationalization of low annuity demand In this case, the average share of wealth annuitized would range from 34% to 69% for the same range of levels of risk aversion. We find that survival pessimism is quantitatively as important as the higher prices caused by adverse selection This result does not depend on other explanations that have been given for non-annuitization; in our model, individuals have only modest social security income, do not have bequest motives, face no medical cost risk, do not have access to means-tested income floors and annuities are priced fairly given objectively-measured survival rates. In all of our analysis, unless otherwise stated, we weight observations by the cross-sectional weights available in the ELSA data
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