Cumulative Prospect Theory, Deferred Annuities and the Annuity Puzzle

20 Pages Posted: 2 Nov 2016

See all articles by Anran Chen

Anran Chen

City University London - Faculty of Actuarial Science

Steven Haberman

City University London - Faculty of Actuarial Science

Steve Thomas

City University London - Sir John Cass Business School

Date Written: November 1, 2016

Abstract

During the past few decades, there has been a steady shift from traditional defined benefit (DB) pension plans to defined contribution (DC) pension plans. In a DC pension plan, retirees have to make decisions on how to spend their accumulated retirement funds. Although it has been proved theoretically that annuities can provide optimal consumption during one’s retirement period, retirees’ reluctance to purchase annuities is a long-standing puzzle. Cumulative Prospect Theory (CPT), which considers both loss aversion and a probability transformation, can explain the low demand for immediate annuities during retirement. It also shows that retirees would be willing to buy a long-term deferred annuity at retirement. By considering each component in CPT, we find that loss aversion is the major reason that stops people from buying an annuity, while the survival rate transformation is an important factor affecting the decision of when to receive annuity incomes.

Keywords: CPT, Deferred annuities, Annuity puzzle, Reservation price

Suggested Citation

Chen, Anran and Haberman, Steven and Thomas, Stephen H., Cumulative Prospect Theory, Deferred Annuities and the Annuity Puzzle (November 1, 2016). Available at SSRN: https://ssrn.com/abstract=2862792 or http://dx.doi.org/10.2139/ssrn.2862792

Anran Chen (Contact Author)

City University London - Faculty of Actuarial Science ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Steven Haberman

City University London - Faculty of Actuarial Science ( email )

London
United Kingdom

Stephen H. Thomas

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
+44 (0) 20 7040 5271 (Phone)
+44 (0) 20 7040 8881 (Fax)

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