PensionReforms' summary and comments

This report looks at the potential impact of annuities on the asset portfolios of retirees.  With the growing number of retirees and the declining proportion of defined pension benefits, more will face the issue of whether and when to convert assets to annuities.

"On the one hand, insurers offer life annuities as the preferred distribution mechanism. On the other, mutual fund providers propose phased withdrawal plans as the better alternative. This paper compares different retirement payout approaches to show how people can optimize their retirement portfolios by simultaneously using investment-linked retirement rules along with life annuities."

The report finds that  "the appropriate mix depends on retiree attitudes toward risk (as well as the underlying economic and demographic assumptions)."

"[W]e compare stand-alone withdrawal rules versus immediate annuitization of the entire portfolio. Consistent with previous studies, we show that annuities are attractive as a stand-alone product when the retiree has sufficiently high risk aversion and lacks a bequest motive. Withdrawal plans dominate annuities for low/moderate risk preferences, because the retiree can gain by investing in the capital market and from "betting on death." 

The report also looks at mixed strategies, finding "that:

· Annuities become appealing for those with moderate risk aversion, when retirees can hold both annuities and phased withdrawal plans as a mixed strategy. Withdrawal plans are now attractive for highly risk-averse retirees.

· From an asset allocation perspective, annuities first crowd out bonds when risk aversion rises. As risk aversion increases further, annuities replace equities in the overall portfolio. When a retiree is permitted to switch into an annuity at some point after the retirement date, we find that the optimal annuitization age is sensitive to the degree of risk aversion and interest rates in the following manner:

· Less risk-averse retirees will wait longer until they switch to an annuity.

· Very risk-averse individuals will be willing to annuitize in a low interest rate environment, but higher interest rates are required to induce annuitization among risk preferrers."

The report concludes that making annuitisation compulsory at any age is unlikely to be optimal for retirees, given the different risk preferences of retirees.  Allowing choice of the purchase date seems best.

PensionReforms notes that developed countries offer tax breaks for retirement saving of the EET type (or a variant) because tax will be payable on the resulting benefits.  Allowing retirees complete freedom may compromise the recovery of the concessions given during the accumulation period.  So, public and private preferences (as illustrated by this report) may well not intersect.  Forcing annuitisation at retirement seems not to be in the best interests of most retirees but allowing complete freedom is not necessarily in the best interests of taxpayers.   59