Optimal Annuity Risk Management

CentER Working Paper Series No. 2006-78

EFA 2007 Ljubljana Meetings Paper

53 Pages Posted: 1 Mar 2007 Last revised: 3 Sep 2009

See all articles by Ralph S. J. Koijen

Ralph S. J. Koijen

University of Chicago - Booth School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Theo Nijman

Tilburg University - Center and Faculty of Economics and Business Administration

Bas J. M. Werker

Tilburg University - Center for Economic Research (CentER)

Date Written: August 30, 2009

Abstract

We study the optimal consumption and portfolio choice problem over an individual's life-cycle taking into account annuity risk at retirement. Optimally, the investor allocates wealth at retirement to nominal, inflation-linked, and variable annuities and conditions this choice on the state of the economy. We also consider the case in which there are, either for behavioral or institutional reasons, limitations in the types of annuities that are available at retirement. We allow for the possibility of a government-provided annuity income. Subsequently, we determine how the investor optimally anticipates annuitization before retirement. We find that (i) using information on both term structure variables and risk premia significantly improves the annuity choice, (ii) annuity market incompleteness is economically costly, and (iii) adjustments in the optimal investment strategy before retirement induced by the annuity demand due to inflation risk and time-varying risk premia are significant in economic terms. This latter result holds as well for sub-optimal annuity choices. The adjustment to hedge real interest rate risk is negligible.

Keywords: optimal life-cycle portfolio choice, annuity risk

JEL Classification: D91, G0, G11, G23

Suggested Citation

Koijen, Ralph S. J. and Nijman, Theo E. and Werker, Bas J.M., Optimal Annuity Risk Management (August 30, 2009). CentER Working Paper Series No. 2006-78; EFA 2007 Ljubljana Meetings Paper. Available at SSRN: https://ssrn.com/abstract=890730 or http://dx.doi.org/10.2139/ssrn.890730

Ralph S. J. Koijen (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

HOME PAGE: http://faculty.chicagobooth.edu/ralph.koijen/

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Theo E. Nijman

Tilburg University - Center and Faculty of Economics and Business Administration ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2342 (Phone)
+31 13 466 3280 (Fax)

Bas J.M. Werker

Tilburg University - Center for Economic Research (CentER) ( email )

Econometrics and Finance Group
5000 LE Tilburg
Netherlands

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