Rethinking the Annuity Puzzle: The Role of Loss Aversion and Money-Back Guarantees

Abstract

We contribute to the resolution of the annuity puzzle by incorporating loss aversion into the preference structures of individuals. Specifically, individuals are averse to the case where death occurs before the sum of payouts exceeds the sum of annuity premiums paid. In realistically calibrated life cycle models with optimal consumption and portfolio choices of risk-averse investors with a bequest motive, we demonstrate that this loss aversion can explain the low demand for life-only annuities. Furthermore, the model predictions align with the evidence that individuals predominantly purchase life annuities with money-back guarantees.

Keywords: annuity puzzle, loss aversion, refundable annuities, life cycle portfolio choice

JEL Classification: D14, D15, G11, G52