Efficient Annuitization with Delayed Payout Annuities

49 Pages Posted: 25 Sep 2006

See all articles by Jason S. Scott

Jason S. Scott

Financial Engines, Inc.

John G. Watson

Financial Engines, Inc.; Stanford Graduate School of Business

Wei-Yin Hu

Financial Engines, Inc.

Date Written: November 2006

Abstract

Contrary to economic theory, few retirees voluntarily annuitize much, if any, of their wealth. This behavior has been at least partly explained by factors such as bequest motives, a demand for liquid wealth, or a restrictive annuity investment universe, all of which impose implicit costs on annuitization. When such costs are considered, utility maximization implies a preference for annuity contracts that are efficient in the sense that they deliver maximum benefit for a given annuity investment. In a standard lifecycle setting, we find that efficient annuity allocations involve no annuity payouts in early years, while later years are fully funded by annuities. Importantly, insurance companies have recently introduced annuity contracts with payouts that begin in the future, referred to as delayed payout annuities. We find that delayed payout annuities are highly efficient. For a typical example, half the potential annuity welfare gains require only a six percent allocation to delayed payout annuities compared to a thirty-nine percent allocation to immediate annuities. Because of their efficiency, delayed payout annuities can substantially improve welfare, particularly for retirees unwilling to annuitize large fractions of their wealth.

Keywords: Annuities, annuitization, Social Security, pensions, longevity risk, insurance

JEL Classification: D11, D91, E21, H55, J14, J26

Suggested Citation

Scott, Jason S. and Watson, John G. and Hu, Wei-Yin, Efficient Annuitization with Delayed Payout Annuities (November 2006). Available at SSRN: https://ssrn.com/abstract=932145 or http://dx.doi.org/10.2139/ssrn.932145

Jason S. Scott (Contact Author)

Financial Engines, Inc. ( email )

1050 Enterprise Way, 3rd Floor
Sunnyvale, CA 94089
United States

John G. Watson

Financial Engines, Inc. ( email )

1050 Enterprise Way
Sunnyvale, CA 94089
United States

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305
United States

Wei-Yin Hu

Financial Engines, Inc. ( email )

1050 Enterprise Way, 3rd Floor
Sunnyvale, CA 94089
United States

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