Dynamic Portfolio Choice with Annuities When the Interest Rate Is Stochastic

Abstract

This paper studies the optimal life cycle consumption and portfolio choice problem taking into account annuity risk due to stochastic interest rates. When the purchase of annuities is restricted to the retirement date, the annuitant is exposed to the risk of meeting low interest rates at the purchase date. This annuity risk can be diversified by spreading annuity purchases over the whole pre-retirement period. The numerical results of our life cycle model show that such temporal diversification enhances welfare for retirees up to 9% of certainty equivalent consumption and that welfare gains increase with higher interest rate risk.

Keywords: annuity risk, deferred life annuities, dynamic portfolio choice, interest rate risk

JEL Classification: D15, G00, G11, J26