Betting on Death and Capital Markets in Retirement: A Shortfall Risk Analysis of Life Annuities versus Phased Withdrawal Plans
Dus, Ivica, Maurer, Raimond, Mitchell, Olivia S., Financial Services Review
Retirees must draw down their accumulated assets in an orderly fashion, so as not to exhaust their funds too soon. We compared alternative phased withdrawal strategies to a life annuity benchmark using German data; one particular phased withdrawal rule seems attractive, as it offers relatively low expected shortfall risk, good expected payouts for the retiree during his life, and some bequest potential. Results are similar for the U.S. case. Delayed annuitization may also appeal, as it offers higher expected benefits with lower expected shortfalls. © 2005 Academy of Financial Services. All rights reserved.
JEL classifications: G22; G23; J26; J32; H55
Keywords: Mortality; Longevity risk; Phased withdrawal; Portfolio management
Economists often advise retirees seeking to spread their assets over their retirement period to purchase a life annuity, which is a financial contract between an insured person and an insurer "that pays out a periodic amount for as long as the annuitant is alive, in exchange for an initial premium" (Brown, Mitchell, Poterba & Warshawsky, 2001). Annuity payments may be fixed in nominal terms (fixed annuity); they can rise at a prespecified fixed nominal escalation rate (graded annuity); or they can be indexed to inflation (real annuity). Alternatively, they may reflect the return of a specific asset portfolio that backs the (variable) annuity, or they can depend on the insurance company's experience with mortality, investment returns, and expenses (participating annuity). As Mitchell, Poterba, Warshawsky, and Brown (1999) note, the essential attraction of a life annuity is that the individual is protected against the risk of outliving his own assets, given uncertainty about his remaining lifetime, by pooling longevity risk across a group of annuity purchasers. Yaari (1965) shows that risk-averse retirees without a bequest motive facing annuity markets that charge actuarially fair premiums should annuitize 100% of their wealth.
Though life annuities provide invaluable longevity insurance, they also have some disadvantages. Most obviously, the purchaser faces loss of liquidity and control over his assets, because the lump sum premium cannot be recovered after purchase of the annuity, irrespective of special needs (e.g., to cover unexpected and uninsured medical costs; cf. Brugiavini, 1993). Also, if the annuity payments are contingent on the individual's survival, there is no chance of leaving a bequest for one's heirs. Other explanations for why people may be reluctant to buy annuities are the high administrative costs levied by insurance companies (Mitchell et al., 1999), the ability to pool longevity risk within families (Brown & Poterba, 2000; Kotlikoff & Spivak, 1981), and the presence of other annuitized resources from Social security or employer-sponsored defined benefits plans (Munnell, Sundén, Mauricio & Taylor, 2002).
As an alternative to buying a life annuity, one might "self-annuitize" using a phased withdrawal approach. Here the retiree allocates his wealth endowment across various asset categories (e.g., equity, bonds, cash) typically included in a family of mutual funds where the assets will earn uncertain rates of return. A certain amount of the invested funds can then be withdrawn periodically for consumption purposes. An advantage of the phased withdrawal strategy, as compared to a life annuity, is that it offers greater liquidity, the possibility of greater consumption while alive, and the possibility of bequeathing some of the assets in the event of early death. On the other hand, relying on a steady asset drawdown without any insurance provides no pooling of longevity risk, so the retiree could outlive his assets before his uncertain date of death. Another withdrawal rule, for example, consuming a specified fraction of the remaining fund wealth each period, avoids the risk of outliving one's total assets, as long as the benefit-to-wealth ratio is lower than one. …