Health Cost Risk and Optimal Retirement Provision

A Simple Rule for Annuity Demand

J.M.J. Peijnenburg, T.E. Nijman, B.J.M. Werker

Research output: Working paperDiscussion paperOther research output

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Abstract

We analyze the effect of health cost risk on optimal annuity demand and consumption/savings decisions. Many retirees are exposed to sizeable out-of-pocket medical expenses, while annuities potentially impair the ability to get liquidity to cover these costs and smooth consumption. We find that if out-of-pocket medical expenses can already be sizeable early in retirement, full annuitization is not optimal. In the other case of low health cost risk early in retirement, individuals should take advantage of the mortality credit that annuities provide and save out of the annuity income to build a buffer for health cost shocks at later ages. When comparing to empirically observed levels of annuitization, we find that high health cost risk early in retirement may resolve the annuity puzzle. Moreover, we explain the observed pattern of annuitization as a function of initial wealth at retirement. For personal financial planning purposes, we develop a simple rule of thumb for annuity demand, based on expected health cost risk early in retirement, wealth at retirement, and minimum consumption levels. We show that the welfare costs from using the rule compared to the full life cycle model are small.
Original languageEnglish
Place of PublicationTilburg
PublisherFinance
Number of pages35
Volume2010-14
Publication statusPublished - 2010

Publication series

NameCentER Discussion Paper
Volume2010-14

Fingerprint

Retirement
Annuities
Health costs
Simple rules
Annuitization
Wealth
Expenses
Life-cycle model
Mortality
Consumption and saving
Income
Rules of thumb
Liquidity
Financial planning
Welfare cost
Buffer
Credit
Costs

Keywords

  • Optimal life cycle portfolio choice
  • health cost risk
  • annuity
  • retirement

Cite this

Peijnenburg, J. M. J., Nijman, T. E., & Werker, B. J. M. (2010). Health Cost Risk and Optimal Retirement Provision: A Simple Rule for Annuity Demand. (CentER Discussion Paper; Vol. 2010-14). Tilburg: Finance.
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Peijnenburg, JMJ, Nijman, TE & Werker, BJM 2010 'Health Cost Risk and Optimal Retirement Provision: A Simple Rule for Annuity Demand' CentER Discussion Paper, vol. 2010-14, Finance, Tilburg.

Health Cost Risk and Optimal Retirement Provision : A Simple Rule for Annuity Demand. / Peijnenburg, J.M.J.; Nijman, T.E.; Werker, B.J.M.

Tilburg : Finance, 2010. (CentER Discussion Paper; Vol. 2010-14).

Research output: Working paperDiscussion paperOther research output

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