Optimal Portfolio Choice with Annuitization

Ralph S.J. Koijen, Theo E. Nijman and Bas J.M. Werker

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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