Rational Decumulation

Wharton Financial Institutions Center Working Paper No. 06-14

35 Pages Posted: 18 Jul 2006  

David F. Babbel

University of Pennsylvania - The Wharton School - Finance and Insurance Departments; CRA International

Craig B. Merrill

Brigham Young University; Wharton Financial Institutions Center

Date Written: July 2006

Abstract

We focus on the decumulation decision that faces an individual upon entering retirement, and seek a rational set of choices for an individual who receives a lump-sum settlement from retirement savings programs, together with accumulated private savings and Social Security credits. In the spirit of Merton (1969, 1971) and Richard (1975), we develop a continuous-time model to study the asset allocation choices, where life annuities are included along with fixed income and equity as the asset classes, and the inflation-protected life annuity is the riskless asset in an intertemporal context with an uncertain lifetime. Unlike previous continuous-time models of annuities, wherein the existence of actuarial notes or instantaneous term annuities is posited and individual behavior relative to these hypothetical annuities is examined, our model accommodates more realistically the principal features and structure of actual annuities that are available - i.e., we consider irrevocable life annuities. Individual behavior differs markedly from earlier studies under a variety of economic conditions. In particular, high levels of annuitization are shown to be rational under a wide range of risk aversion levels, even when stock market returns and annuity price loadings are assumed to be much greater than is generally the case. Ours is also the first study to model individual behavior under the possibility of default by the insurer issuing annuities. We find that even a little default risk can have a very large impact on annuity purchase decisions. We further find that state insolvency guaranty programs can have a big impact upon the levels of rational life annuity purchases - particularly annuities of large size. This occurs even if the guaranty limits are relatively low. Higher guaranty limits have a much smaller incremental impact on annuity purchases. Insurers with lower credit ratings may benefit relatively more from such programs.

Keywords: Annuities, Asset allocation, Retirement, Default, Insurance

JEL Classification: C61, D14, D91, G11, G22, G28, H55, J26

Suggested Citation

Babbel, David F. and Merrill, Craig B., Rational Decumulation (July 2006). Wharton Financial Institutions Center Working Paper No. 06-14. Available at SSRN: https://ssrn.com/abstract=917223 or http://dx.doi.org/10.2139/ssrn.917223

David F. Babbel (Contact Author)

University of Pennsylvania - The Wharton School - Finance and Insurance Departments ( email )

215 Wakefield Road
Bryn Mawr, PA 19010
United States
610-527-1839 (Phone)

CRA International ( email )

John Hancock Tower
200 Clarendon Street, T-33
Boston, MA 02116-5092
United States
610-527-1839 (Phone)

Craig B. Merrill

Brigham Young University ( email )

Provo, UT 84602
United States
(801) 422-4782 (Phone)

Wharton Financial Institutions Center ( email )

2306 Steinberg Hall-Dietrich Hall
3620 Locust Walk
Philadelphia, PA 19104
United States

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