Optimal Portfolio Choice with Annuitization

R.S.J. Koijen, T.E. Nijman, B.J.M. Werker

Research output: Working paperDiscussion paperOther research output

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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.Subsequently, we determine how the investor optimally anticipates annuitization before retirement.We find that i) using information on term structure variables and risk premia significantly improves the optimal annuity choice, ii) restricting the annuity menu to nominal or inflation-linked annuities is costly for both conservative and more aggressive investors, 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 economically significant.This holds as well for sub-optimal annuity choices.The adjustment to hedge real interest rate risk is negligible.We estimate that the welfare costs of not taking these three factors into account at retirement are 9% for an individual with an average risk aversion ( = 5).Not hedging annuity risk before retirement causes an additional welfare costs between 1% and 13%, depending on the annuitization strategy implemented at retirement.
Original languageEnglish
Place of PublicationTilburg
PublisherFinance
Number of pages46
Volume2006-78
Publication statusPublished - 2006

Publication series

NameCentER Discussion Paper
Volume2006-78

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Optimal portfolio choice
Annuitization
Retirement
Annuities
Investors
Inflation
Welfare cost
Risk premia
Hedging
Hedge
Interest rate risk
Wealth
Optimal portfolio
Time-varying risk
Variable annuities
Optimal investment strategy
Life cycle
Inflation risk
Risk aversion
Portfolio choice

Keywords

  • optimal life-cycle portfolio choice
  • annuity risk

Cite this

Koijen, R. S. J., Nijman, T. E., & Werker, B. J. M. (2006). Optimal Portfolio Choice with Annuitization. (CentER Discussion Paper; Vol. 2006-78). Tilburg: Finance.
Koijen, R.S.J. ; Nijman, T.E. ; Werker, B.J.M. / Optimal Portfolio Choice with Annuitization. Tilburg : Finance, 2006. (CentER Discussion Paper).
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Koijen, RSJ, Nijman, TE & Werker, BJM 2006 'Optimal Portfolio Choice with Annuitization' CentER Discussion Paper, vol. 2006-78, Finance, Tilburg.

Optimal Portfolio Choice with Annuitization. / Koijen, R.S.J.; Nijman, T.E.; Werker, B.J.M.

Tilburg : Finance, 2006. (CentER Discussion Paper; Vol. 2006-78).

Research output: Working paperDiscussion paperOther research output

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AB - 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.Subsequently, we determine how the investor optimally anticipates annuitization before retirement.We find that i) using information on term structure variables and risk premia significantly improves the optimal annuity choice, ii) restricting the annuity menu to nominal or inflation-linked annuities is costly for both conservative and more aggressive investors, 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 economically significant.This holds as well for sub-optimal annuity choices.The adjustment to hedge real interest rate risk is negligible.We estimate that the welfare costs of not taking these three factors into account at retirement are 9% for an individual with an average risk aversion ( = 5).Not hedging annuity risk before retirement causes an additional welfare costs between 1% and 13%, depending on the annuitization strategy implemented at retirement.

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Koijen RSJ, Nijman TE, Werker BJM. Optimal Portfolio Choice with Annuitization. Tilburg: Finance. 2006. (CentER Discussion Paper).