Optimal Annuitization with Stochastic Mortality Probabilities: Working Paper 2013-05

By Felix Reichling and Kent Smetters

Economic modeling dating back to Yaari (1965) shows that individuals who do not aim to leave bequests to future generations should put all of their investments into annuities rather than alternatives such as bonds. Annuities offer higher returns than alternative investment options and protect against longevity risk—they provide income in each remaining year of life, even if an individual lives for an usually long time.

This paper models decisions about purchasing annuities in a context where individuals learn new information about their health status over time (that is, with stochastic mortality risk). In that context, the value of an annuity declines when an individual experiences an adverse health shock that lowers her life expectancy. Because of that valuation risk, risk-averse individuals will not want to fully annuitize their investments when they face higher costs or lower income in bad health. We find that most households should not annuitize any wealth. The optimal level of aggregate net annuity holdings is likely even negative.