Optimal Annuity Risk Management
Ralph S. J. Koijen
London Business School - Department of Finance; National Bureau of Economic Research (NBER)
Tilburg University - Center and Faculty of Economics and Business Administration
Bas J. M. Werker
Tilburg University - Center for Economic Research (CentER)
August 30, 2009
CentER Working Paper Series No. 2006-78
EFA 2007 Ljubljana Meetings Paper
We study the optimal consumption and portfolio choice problem over an individual's life-cycle taking into account annuity risk at retirement. Optimally, the investor allocates wealth at retirement to nominal, inflation-linked, and variable annuities and conditions this choice on the state of the economy. We also consider the case in which there are, either for behavioral or institutional reasons, limitations in the types of annuities that are available at retirement. We allow for the possibility of a government-provided annuity income. Subsequently, we determine how the investor optimally anticipates annuitization before retirement. We find that (i) using information on both term structure variables and risk premia significantly improves the annuity choice, (ii) annuity market incompleteness is economically costly, and (iii) adjustments in the optimal investment strategy before retirement induced by the annuity demand due to inflation risk and time-varying risk premia are significant in economic terms. This latter result holds as well for sub-optimal annuity choices. The adjustment to hedge real interest rate risk is negligible.
Number of Pages in PDF File: 53
Keywords: optimal life-cycle portfolio choice, annuity risk
JEL Classification: D91, G0, G11, G23
Date posted: March 1, 2007 ; Last revised: September 3, 2009
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