by Svetlana Pashchenko, University of Virginia
A major risk people face towards the end of a life-cycle is the risk of outliving their assets or longevity risk. The use of private insurance against this risk is very limited, however: the market for life annuities is almost nonexistent.
The future role of private insurance against longevity risk is currently under debate in retirement literature. The transition from Defined Benefits (DB) to Defined Contributions (DC) pension plans has increased households’ exposure to longevity risk. Social Security privatization proposals would eliminate public longevity insurance. Thus future retirees will have to take greater responsibility in managing their longevity risk. To better understand what challenges and opportunities this new environment brings it is important to know the reasons for very limited current use of private longevity insurance.
The lack of interest in annuities has been attributed in the literature to bequest motives, a high fraction of preannuitized wealth, adverse selection, and risk of incurring high health expenditures. Each of the above factors can decrease value of annuitization, but none of them alone can explain the almost total absence of life annuities in household portfolios. To fully account for the so called “annuity puzzle” one needs to combine all of these impediments to annuitization.
This project aims to contribute to the literature by answering the following question: how quantitatively important are the commonly cited reasons for non-annuitization? The results of this quantitative exercise can be used to analyze market responses to the changing circumstances noted above and welfare effects of policy intervention.
The approach in this project is to construct a life-cycle model for retired individuals who choose asset decumulation strategy in a presence of lifespan uncertainty and medical expense risk. Retirees have an option to buy annuity to insure against longevity risk. Agents in the model are assumed to be heterogeneous by health and wealth level. The association between wealth, health and mortality is going to be modeled explicitly. This will allow the reasons for non-annuitization to be different for people with different wealth levels.
Another important feature of the model is the equilibrium approach to annuity market. This allows me to consider feedback effects from price and take into account interaction between different factors affecting annuitization decision.
The model is going to be calibrated from the Assets and Health Dynamics of the Oldest Old (AHEAD) dataset. The calibrated model is going to be used for a set of counterfactual and policy experiments in order to quantify the factors behind annuity puzzle and determine what kind of interventions can provide better longevity risk protection for retirees.