Wharton Pension Research Council Working Papers
 

Document Type

Working Paper

Date of this Version

2007

Abstract

As baby boomers enter retirement, they will look to the investment industry for ways to generate retirement income from a stock of accumulated saving. A longstanding puzzle is why most retirees do not purchase longevity insurance in the form of lifetime annuities. This question is rising in importance due to the rapid decline of defined benefit pensions, which traditionally provided such guaranteed lifetime income. This study applies the lessons of behavioral finance to understand how well-documented anomalies in decision-making under risk may affect the annuity purchase decision. We demonstrate how mental accounting—where an annuity is evaluated as a gamble distinct from the retirement spending and investment plan—can be a powerful reason for the unpopularity of annuities. We also explain the prevalence of “period certain” annuities which guarantee a minimum number of payouts. Finally, we show that delayed payout or “longevity annuities,” which are purchased today to begin payouts in the future, may be more desirable than immediate payout annuities due to the overweighting of small probabilities.

Keywords

annuities, behavioral, prospect theory

JEL Code

D11, D91, H55, J14, J26

Working Paper Number

WP2007-10

Copyright/Permission Statement

Opinions and errors are solely those of the authors and not of the institutions with whom the authors are affiliated. © 2007 Pension Research Council. All rights reserved.

Acknowledgements

The authors thank William Sharpe, Geert Bekaert, Steve Grenadier, Jim Shearer, Melinda Deutsch, and Irene Gitin for many excellent comments and suggestions. Any remaining errors or omissions are the authors' responsibility.

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Economics Commons

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Date Posted: 17 December 2019