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Optimal Initiation of a GLWB in a Variable Annuity: No Arbitrage Approach

23 Pages Posted: 26 Feb 2013  

Moshe A. Milevsky

York University - Schulich School of Business

Huang Huaxiong

York University

T. S. Salisbury

York University

Date Written: February 25, 2013

Abstract

This paper offers a financial economic perspective on the optimal time (and age) at which the owner of a Variable Annuity (VA) policy with a Guaranteed Living Withdrawal Benefit (GLWB) rider should initiate guaranteed lifetime income payments. We abstract from utility, bequest and consumption preference issues by treating the VA as liquid and tradable. This allows us to use an American option pricing framework to derive a so-called optimal initiation region. Our main practical finding is that given current design parameters in which volatility (asset allocation) is restricted to less than 20%, while guaranteed payout rate (GPR) as well as bonus (roll-up) rates are less than 5%,GLWBs that are in-the-money should be turned on by the late 50s and certainly the early 60s. The exception to the rule is when a non-constant GPR is about to increase (soon) to a higher age band, in which case the optimal policy is to wait until the new GPR is hit and then initiate immediately. Also, to offer a different perspective, we invert the model and solve for the bonus (roll-up) rate that is required to justify delaying initiation at any age. We find that the required bonus is quite high and more than what is currently promised by existing products. Our methodology and results should be of interest to researchers as well as to the individuals that collectively have over $1 USD trillion in aggregate invested in these products. We conclude by suggesting that much of the non-initiation at older age is irrational (which obviously benefits the insurance industry.)

Keywords: Insurance, Retirement, Options, Longevity, Optimization

JEL Classification: G11, D14, C61, G22, D91

Suggested Citation

Milevsky, Moshe A. and Huaxiong, Huang and Salisbury, T. S., Optimal Initiation of a GLWB in a Variable Annuity: No Arbitrage Approach (February 25, 2013). Available at SSRN: https://ssrn.com/abstract=2224181 or http://dx.doi.org/10.2139/ssrn.2224181

Moshe Arye Milevsky (Contact Author)

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada

Huang Huaxiong

York University ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada

Tom S. Salisbury

York University ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada

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