Full Annuitization Research Articles

Understanding demand for flexible pension payouts: evidence from the Netherlands

AbstractThis study examines the interest in different pension payout schemes when full annuitization is the default. We focus on three possible pension payout schemes: a flat-rate annuity, a high/low annuity-based profile, and a partial lump sum at retirement with a lower flat-rate annuity after that. We make use of a vignette study and find substantial interest in each of the three payout schemes. Interest in the lump sum scheme increases when a higher percentage can be taken out as a lump sum or when interest rates or replacement rates are lower. Interest in a high/low annuity-based profile increases when the high annuity is valid for a shorter period.

Practical Applications of Employee Opinions about Partial Annuitization in a Retirement Plan

In <b><i>Employee Opinions about Partial Annuitization in a Retirement Plan</i></b>, from the Winter 2022 issue of <b><i>The Journal of Retirement</i></b>, authors Michael Finke (of <b>The American College of Financial Services</b>) and Jason J. Fichtner (of the <b>Bipartisan Policy Center</b>) report the results of a survey they conducted among defined-contribution (DC) retirement plan participants that measures interest in allocating contributions to an annuity option inside the plan. Annuities are not popular with retirement savers, but past researchers have asked savers only if they planned to put all or none of their retirement savings into annuities. Instead, the authors asked savers if they wanted the option of putting some of their retirement savings into annuities for lifetime income. The authors reported that 49.5% of respondents preferred a plan that offers stocks, bonds, and annuities; 24% preferred full annuitization; and 26.5% preferred only stocks and bonds. Respondents indicated they would allocate an average of 33.5% of savings to annuities to receive guaranteed lifetime income. The authors say that if plan administrators wish to encourage allocations to annuities, they should frame them as guaranteeing participants the ability to maintain a stable level of spending every year for life.

Saving preferences after retirement

We investigate the importance of alternative motives for saving and spending patterns after retirement in the Netherlands and Australia. Using an online experimental survey, we elicit the impact on advised spending patterns and underlying saving motives of alternative retirement drawdown designs, ranging from complete flexibility in Australia to full annuitization in the Netherlands, and of major life events such as becoming frail or losing a spouse. We find that important motives for spending and saving after retirement in both countries are the desire to remain financially independent and to ensure that it is possible to enjoy life now as well as later. However, consistent with differences in real world pension settings, life span risk is more important and liquidity less important in Australia than in the Netherlands. With the exception of inter vivos transfers to a surviving spouse, the bequest motive is not important in either country. Our results suggest that an important reason for the widespread behaviour of retirees to hold on to their wealth might be the desire to hold precautionary savings for health and long-term care expenditures. We also find that individuals revise their saving motives in anticipation of major life events but are less responsive to variation in ‘experimental’ retirement drawdown arrangements, remaining aligned to the prevailing institutional arrangements in their country.

Is full annuitization socially optimal?

Is full annuitization socially optimal?

When saving is not enough – wealth decumulation in retirement

AbstractWe field a large online survey to study preferences and hypothetical product choices for phased withdrawal accounts and compare their demand to the demand of annuities. We find that most individuals prefer phased withdrawal accounts with dynamic withdrawal rates and equity-based asset allocation. Additionally, when offered the opportunity to exchange the phased withdrawal account with an annuity, most individuals decline to annuitize. Our results suggest that policymakers should consider offering combined solutions of phased withdrawals and annuities. Retirees who are averse to full annuitization could preserve some of their accumulated wealth while also acquiring protection against longevity risk.

The Impact of Health Status and Out-of-Pocket Medical Expenditures on Annuity Valuation

This paper describes how differences in health status at retirement can influence the decision to purchase a life annuity. We extend previous research on annuitization decisions by incorporating the effect of health differentials via differences in survival throughout the latter portion of life. Next, we consider how precautionary savings motivated by uncertain out-of-pocket medical expenses influence annuitization decisions. Our results show that annuities become less attractive to people facing uncertain medical expenses. While full annuitization would still be optimal if annuity markets were truly complete and both life- and health-contingent, lacking this, annuity equivalent wealth values are much lower for those in poor health, as compared to persons in good health.

Framing and the annuitization decision – Experimental evidence from a Dutch pension fund

AbstractWe report the effects of framing settings in annuity demand after conducting a survey-based experiment with members of a Dutch occupational pension plan. We gave participants the option to allocate up to 20% of their projected pension accrual to a lump sum. In particular, we investigated the joint effects of consumption and investment frames and gain and loss frames. We present strong evidence for framing effects in annuity demand. Framing effects remain significant when we control for individual characteristics. We also find robust evidence of individual characteristics influencing annuity demand, highlighting the importance of heterogeneity among participants, for example risk aversion, time preference and trust in the pension fund. Gender and long-term debt positions have significant impact how one responds to framing. We conclude that Dutch plan members generally welcome the partial lump sum option over mandatory full annuitization. The application of frames appears to predictively steer annuity demand. The precise effect framing may have, would probably also depend on the institutional environment, which predefines the perspective through which individuals filter annuities.

Life Annuities. Products, Guarantees, Basic Actuarial Models.

These Lecture Notes aim at introducing technical and financial aspects of the life annuity products, with a special emphasis on the actuarial valuation of life annuity benefits. The text has been planned assuming as target readers:- advanced undergraduate and graduate students in Economics, Business and Finance;- advanced undergraduate students in Mathematics and Statistics, possibly aiming at attending, after graduation, actuarial courses at a master level;- professionals and technicians operating in insurance and pension areas, whose job may regard investments, risk analysis, financial reporting, and so on, hence implying communication with actuarial professionals and managers.Given the assumed target, the use of complex mathematical tools has been avoided.We assume that the reader has attended courses providing basic notions of Financial Mathematics (interest rates, compound interest, present values, accumulations, annuities, etc.) and Probability (probability distributions, conditional probabilities, expected value, variance, etc). As mentioned, Mathematics has been kept at a rather low level. Indeed, all topics are presented in a “discrete” framework, thus not requiring analytical tools like differentials, integrals, etc.The Lecture Notes are organized as follows. Guarantees and options in life contingency products, and in life annuities in particular, are sketched in Chap. 1. In Chap. 2 the basic actuarial aspects are introduced with reference to conventional life annuity products, starting from expected present value definitions, then moving to premium and reserve calculations.A more general framework is proposed in Chap. 3, in order to introduce a wide range of life annuity products. The guarantee structure implied by various products is analyzed in Chap. 4, while Chap. 5 focusses on the time profile of the annuity benefits.Options and riders which can be added to life annuity products are dealt with in Chap. 6, while Chap. 7 focusses on annuity rates adopted to determine the annuity premiums. Cross-subsidy mechanisms working in life annuity portfolios are addressed in Chap. 8, where special attention is placed on “tontine” schemes.Strategies, which can be adopted to get the post-retirement income and, to some extent, can constitute alternatives to the immediate full annuitization of resources available at retirement, are described in Chap. 9.Long-term care insurance (LTCI) is briefly addressed in Chap. 10, with a special focus on life annuity benefits combined with LTCI benefits. Finally, Chap. 11 concludes with suggestions for further reading.

The annuity puzzle remains a puzzle

We examine incomplete annuity menus, background risk, bequest motives, and default risk as possible drivers of divergence from full annuitization. Contrary to what is often suggested in the literature, we find that full annuitization remains optimal if saving is possible after retirement. This holds irrespective of whether real or only nominal annuities are available. Whenever liquidity is desired, individuals save sizeable amounts out of their annuity income to smooth consumption shocks. Similarly, adding equity-linked annuities to the menu does not increase welfare significantly, since individuals can invest in stocks in order to get the desired equity exposure.

Framing and the Annuitization Decision: Experimental Evidence from a Dutch Pension Fund

We report the effects of framing and default settings in annuity demand after conducting a survey-based experiment with over 3,000 members of a Dutch occupational pension plan. The participants were asked to allocate their real projected pension accrual between a life annuity and a partial lump sum. In particular, we investigated the joint effects of consumption and investment frames and gain and loss frames. We present strong evidence for framing and default setting effects in annuity demand. We also find robust evidence of individual characteristics of influence annuity demand, highlighting the importance of heterogeneity among participants. Framing and default effects remain significant when we control for individual characteristics. We conclude Dutch plan members generally welcome the partial lump sum option over full annuitization. Framing and default settings are generally capable of predictively steering annuity demand. The precise effect framing may have also depends on the institutional environment, which predefines the perspective through which individuals filter annuities.

A generalization of Yaari’s result on annuitization with optimal retirement

In this paper we generalize the following result of Yaari (1965) on annuitization with an agent’s optimal retirement: it is optimal for individuals to annuitize all of their wealth in the absence of bequest motive. We have other results that refine or extend the result of Yaari (1965). Full annuitization can be viewed as an American-type option that allows an economic agent to exchange the value of labor income with the extra leisure that is brought about by annuitizing all of her wealth. When the agent’s wealth is above a certain wealth threshold, annuitization is triggered, otherwise it is not. Accordingly, wealth plays a key role in controlling the distance to full annuitization.

A Generalization of Yaari's Result on Annuitization with Optimal Retirement

In this paper we generalize the following result of Yaari (1965) on annuitization with an agent's optimal retirement: it is optimal for individuals to annuitize all of their wealth in the absence of bequest motive. We have other results that refine or extend the result of Yaari (1965). Full annuitization can be viewed as an American-type option that allows an economic agent to exchange the value of labor income with the extra leisure that is brought about by annuitizing all of her wealth. When the agent's wealth is above a certain wealth threshold, annuitization is triggered, otherwise it is not. Accordingly, wealth plays a key role in controlling the distance to full annuitization.

A TRAGEDY OF ANNUITIZATION? LONGEVITY INSURANCE IN GENERAL EQUILIBRIUM

We study the microeconomic and macroeconomic effects of longevity insurance. Using a tractable discrete-time overlapping-generations model of a closed economy we first study different types of government redistribution of accidental bequests in general equilibrium. Individuals face longevity risk, as there is a positive probability of passing away before the retirement period. We find nonpathological cases where it is better for long-run welfare to waste accidental bequests than to give them to the elderly. Next we study the introduction of a perfectly competitive life insurance market offering actuarially fair annuities. There exists a tragedy of annuitization: although full annuitization of assets is privately optimal, it is not socially beneficial, because of adverse general equilibrium repercussions.

Maximizing the utility of consumption with commutable life annuities

The purpose of this paper is to reveal the relation between commutability of life annuities and retirees’ willingness to annuitize. To this end, we assume the existence of commutable life annuities, whose surrender charge is a proportion of their actuarial value. We model a retiree as a utility-maximizing economic agent who can invest in a financial market with a risky and a riskless asset and who can purchase or surrender commutable life annuities. We define the wealth of an individual as the total value of her risky and riskless assets, which is required to be non-negative during her lifetime. We exclude the actuarial value of her annuity income in calculating wealth; therefore, we do not allow the individual to borrow from her future annuity income because this income is contingent on her being alive.We solve this incomplete-market utility maximization problem via duality arguments and obtain semi-analytical solutions. We find that the optimal annuitization strategy depends on the size of proportional surrender charge, with lower proportional surrender charges leading to more annuitization. We also find that full annuitization is optimal when there is no surrender charge or when the retiree is very risk averse. Surprisingly, we find that in the case for which the proportional surrender charge is larger than a critical value, it is optimal for the retiree to behave as if annuities are not commutable. We provide numerical examples to illustrate our results.

The Annuity Puzzle Remains a Puzzle

We examine incomplete annuity menus, background risk, bequest motives, and default risk as possible drivers of divergence from full annuitization. Contrary to what is often suggested in the literature, we find that full annuitization remains optimal if saving is possible after retirement. This holds irrespective of whether real or only nominal annuities are available. Whenever liquidity is desired, individuals save sizeable amounts out of their annuity income to smooth consumption shocks. Similarly, adding equity-linked annuities to the menu does not increase welfare significantly, since individuals can invest in stocks in order to get the desired equity exposure.

Health Cost Risk and Optimal Retirement Provision: A Simple Rule for Annuity Demand

We analyze the effect of health cost risk on optimal annuity demand and consumption/savings decisions. Many retirees are exposed to sizeable out-of-pocket medical expenses, while annuities potentially impair the ability to get liquidity to cover these costs and smooth consumption. We find that if out-of-pocket medical expenses can already be sizeable early in retirement, full annuitization is not optimal. In the other case of low health cost risk early in retirement, individuals should take advantage of the mortality credit that annuities provide and save out of the annuity income to build a buffer for health cost shocks at later ages. When comparing to empirically observed levels of annuitization, we find that high health cost risk early in retirement may resolve the annuity puzzle. Moreover, we explain the observed pattern of annuitization as a function of initial wealth at retirement. For personal financial planning purposes, we develop a simple rule of thumb for annuity demand, based on expected health cost risk early in retirement, wealth at retirement, and minimum consumption levels. We show that the welfare costs from using the rule compared to the full life cycle model are small.

A tFragedy of Annuitization? Longevity Insurance in General Equilibrium

We construct a tractable discrete-time overlapping generations model of a closed economy and use it to study government redistribution of accidental bequests and private annuities in general equilibrium. Individuals face longevity risk as there is a positive probability of passing away before the retirement period. We find non-pathological cases where it is better for long-run welfare to waste accidental bequests than to give them to the elderly. Next we study the introduction of a perfectly competitive life insurance market offering actuarially fair annuities. There exists a tragedy of annuitization: although full annuitization of assets is privately optimal it is not socially beneficial due to adverse general equilibrium repercussions.

Maximizing the Utility of Consumption with Reversible Annuities

The purpose of this paper is to reveal the relation between the reversibility of annuities and retirees' reluctance to annuitize. To this end, we assume the existence of reversible annuities, whose surrender charge is a proportion of their purchase value. We model a retiree as a utility-maximizing economic agent who can invest in a financial market with a risky and a riskless asset and who can purchase or surrender reversible annuities. We define the wealth of an individual as the total value of her risky and riskless assets, which is required to be non-negative during her lifetime. We solve this incomplete market utility maximization problem via duality arguments and obtain semi-analytical solutions. We find that the optimal annuitization strategy depends on the size of proportional surrender charge, with lower proportional surrender charges leading to more annuitization. We also find that full annuitization is optimal when there is no surrender charge or when the retiree is very risk averse. Surprisingly, we find that in the case for which the proportional surrender charge is larger than a critical value, an individual behaves as if annuities are not reversible at all. Numerical examples are given to illustrate our results.

Health Cost Risk and Optimal Retirement Provision: A Simple Rule for Annuity Demand

We analyze the effect of health cost risk on optimal annuity demand and consumption/savings decisions. Many retirees are exposed to sizeable out-of-pocket medical expenses, while annuities potentially impair the ability to get liquidity to cover these costs and smooth consumption. We find that if out-of-pocket medical expenses can already be sizeable early in retirement, full annuitization is not optimal. In the other case of low health cost risk early in retirement, individuals should take advantage of the mortality credit that annuities provide and save out of the annuity income to build a buffer for health cost shocks at later ages. When comparing to empirically observed levels of annuitization, we find that high health cost risk early in retirement may resolve the annuity puzzle. Moreover, we explain the observed pattern of annuitization as a function of initial wealth at retirement. For personal financial planning purposes, we develop a simple rule of thumb for annuity demand, based on expected health cost risk early in retirement, wealth at retirement, and minimum consumption levels. We show that the welfare costs from using the rule compared to the full life cycle model are small.

Optimal Annuitization with Background Risk and Equity Exposure During Retirement

We analyze annuity demand in a realistic life-cycle model in which we optimize over consumption and asset allocation. We incorporate background risk and incomplete annuity menus as possible drivers of deviations from full annuitization. Retirees face longevity ris k, capital market risk, inflation risk, and background risk. We model annuitization as a one-time decision at retirement. Contrary to what is often suggested in the literature, we find that in these settings full annuitizatio n remains close to optimal, irrespective of whether real or only nominal annuities are available. Under all circ umstances we find optimal annuitization levels above 95% of initial wealth. On the one hand annuitization is attractive due to the additional wealth created by the mortality credit, on the other hand annuities are irre versible and the annuity menu is incomplete. We show that the additional wealth effect dominates, optimally individuals annuitize almost their entire wealth at retirement to capture the mortality credit. Whenever liq uidity or equity exposure is desired, individuals save sizeable amounts out of their annuity income to smooth shocks due to background or inflation risk and/or to get equity exposure. We can identify this result, because we do not assume a priori that consumption equals annuity income in retirement and solve a dynamic programming problem for consumption and savings. Similarly, adding variable annuities to the menu does not increase welfare significantly, since individuals can save in order to get the desired equity exposure. Furthermore we find that for individuals who do not face (real) background risk, it is optimal to annuitiz e substantially less to receive the equity premium. Hence if both possible motives to annuitize less are considered jointly, they generally interact in such a way that full annuitization is optimal.