The Real Option to Delay Annuitization: It's Not Now-or-Never

York-Schulich-Finance Working Paper No. MM11-1

44 Pages Posted: 8 Nov 2001

See all articles by Moshe A. Milevsky

Moshe A. Milevsky

York University - Schulich School of Business

V.R. Young

University of Michigan at Ann Arbor - Department of Mathematics

Date Written: November 2001


Asset allocation during the retirement years has not received as much attention as allocation prior to retirement. Within the context of financial planning towards the end of the life-cycle, the economics literature is puzzled over the extremely low levels of voluntary annuitization exhibited amongst the elderly. This phenomenon is inconsistent with a strict interpretation of the Modigliani life-cycle hypothesis. Although many plausible explanations have been suggested to reconcile theory and practice, none seem to contain any rigorous normative financial advice on when and if one should purchase an immediate annuity. This is particularly relevant given the increasing number of Defined Contribution pension plans in the U.S., within which the participants have to manage the risk of outliving their resources, and the corresponding trend away from Defined Benefit plans.

In contrast to a classical economic approach - and motivated by the financial derivatives literature - this paper focuses attention on the Real Option embedded in the decision to annuitize. Indeed, a fixed immediate life annuity can be viewed as a project with a positive net-present value when compared to maintaining liquid wealth in non-annuitized assets. However, this project should nevertheless be deferred, since the option to wait and annuitize later has value. This result is driven by the higher possible risk-adjusted returns from alternative asset classes in the early stages of retirement, as well as possible asymmetries in mortality rates between subjective health status and objective annuity pricing.

Practically speaking, we estimate that the real option to defer annuitization (RODA) is quite valuable until the mid-70s or mid-80s (depending on one's gender and risk aversion), at which point fixed immediate life annuities become the optimal asset class. Moreover, individuals with a higher risk tolerance and greater health asymmetry are endowed with an even larger option value to wait. However, low-cost variable immediate annuities, which are currently not widely available but which provide complete control over the asset allocation process within an immediate annuity wrapper, greatly reduce the option value to wait and create large welfare gains.

Keywords: Retirement, Asset Allocation, Longevity Risk, Mortality

JEL Classification: J26, G11

Suggested Citation

Milevsky, Moshe Arye and Young, Virginia R., The Real Option to Delay Annuitization: It's Not Now-or-Never (November 2001). York-Schulich-Finance Working Paper No. MM11-1, Available at SSRN: or

Moshe Arye Milevsky (Contact Author)

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3

Virginia R. Young

University of Michigan at Ann Arbor - Department of Mathematics ( email )

2074 East Hall
530 Church Street
Ann Arbor, MI 48109-1043
United States
734-764-7227 (Phone)

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