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The Annuity Puzzle

Richard MacMinn
Illinois State University

Presentation at L5
The Fifth International Longevity Risk and Capital Market Solutions Conference
New York, New York
September 25, 2009
Literature
 Yaari, M. (1965). "Uncertain Lifetime, Life Insurance, and the Theory of the Consumer."
The Review of Economic Studies 32: 137-150.
 Davidoff, T., J. R. Brown, et al. (2005). "Annuities and Individual Welfare." American
Economic Review 95(5): 1573 - 1590.
 Warshawsky, M. (1988). "Private Annuity Markets in the United States: 1919-1984."
Journal of Risk and Insurance 55(3): 518-528.
 Friedman, B. M. and M. J. Warshawsky (1990). "The cost of annuities: implications for
saving behavior and bequests." Quarterly Journal of Economics 105(1): 135-154.
 Poterba, J. M. (2001). "Annuity Markets and Retirement Security." Fiscal Studies 22: 249-
279.
 Inkmann, J., P. Lopes, et al. (2007). How deep is the Annuity Market Participation
Puzzle?, Working Paper, presented at CESifo Venice Summer Institute.
 Purcal, S. and J. Piggott (2008). "Explaining Low Annuity Demand: An Optimal Portfolio
Application to Japan." Journal of Risk and Insurance 75(2): 493-516.
 Lockwood, L. (2009). Bequest Motives and the Annuity Puzzle. Chicago, University of
Chicago.
 Sinclair, S. H. and K. A. Smetters (2004). Health Shocks and the Demand for Annuities.
Washington, DC, Congressional Budget Office.
 Sheshinski, E. (2008). The Economic Theory of Annuities. Princeton, Princeton University
Press.
 Cannon, E. and I. Tonks (2008). Annuity Markets. Oxford, Oxford University Press.

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The Classic Economic Paradigm
Portfolio Model
◦ Dates now and then
◦ The consumer/investor selects a portfolio now
of annuities, bonds and life insurance
◦ The portfolio payoff occurs then
◦ The investor survives or not to obtain the
portfolio payoff then
◦ The investor exhibits selfish behavior

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Portfolio Model
The portfolio is    a , b , l 
The survival probability is 1  q 
The annuity, bond and life insurance
prices are  pa , pb , pl 
The consumption now and then depend
on the portfolio choices

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Portfolio Model
Consumption now and then are
c0  w  pa a  pb b  pl l
 0 q
c1  
a  b 1  q
Given a utility function u. Expected
utility is
F ( )  u  w  pa a  pb b  pl l ,0  q
 u  w  pa a  pb b  pl l , a  b  (1  q)

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First Order Conditions
The conditions for an optimal portfolio
are:
F
D1 F    D1u pa q  D1u pa (1  q)  D2u (1  q )
a
F
D2 F    D1u pb q  D1u pb (1  q )  D2u (1  q )
b
F
D3 F    D1u pl q  D1u pl (1  q )  0
l

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The Life Insurance Puzzle
The classic economic paradigm yields the
result that the individual purchases no
insurance since
D3 F   D1u pl q  D1u pl (1  q )
 pl   D1u q  D1u (1  q ) 
0

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The Annuity Puzzle
The annuity puzzle can be demonstrated
by noting the expected marginal utility in
the direction v   1, 1,0 

Dv F  D1 F  D2 F
  D1u pa q  D1u pa (1  q )  D2u (1  q )
 D1u pb q  D1u pb (1  q )  D2u (1  q )
  pb  pa   D1u q  D1u (1  q )
0

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A New Economic Paradigm
Suppose the individual is an altruist, at
least with respect to one significant other.
Let the individual have preferences
defined on the consumption pair ci and the
utility v of the significant other
◦ Utility increases in consumption now and then
◦ Utility also increases in the utility of the
significant other

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Portfolio Theory again
Consumption now and then for the
individual and significant other
c0i   1     w  pa a  pb b  pl l 

c0s    w  pa a  pb b  pl l 

c1id q  0 q
c1i   
 c1il 1  q (1   )  a  b  1  q

c1sd q  b  l q
c1s   
 c1sl 1  q   a  b  1  q

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Portfolio Theory again
The expected utility in the new paradigm
is
H ( )  u  c0i , c1id , v(c0 s , c1sd )  q  u  c0i , c1il , v(c0 s , c1sl )  (1  q)

The first order conditions are



D1H  D1u  1      pa    D3u D1v    pa   q 
 
 D1u  1      pa    D2u  1     D3u D1v    pa    D3u D2 v   1  q 
  pa M   D2u  1     D3u D2v    1  q 

M   D u  1     D u D v q   D u  1     D u D v  1  q  
1 3 1 1 3 1

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Portfolio Theory again
First order conditions continued

D2 H  D1u  1      pb    D3u D1v    pb   q
 
 D1u  1      pb    D2u  1     D3u D1v    pb    D3u D2 v   1  q 
  pb M  D3u D2v q   D2u  1     D3u D2v    1  q 

D3 H   pl   D u  1     D u D v q   D u  1     D u D v  1 q 
1 3 1 1 3 1

 D3u D2v q
  pl M  D3u D2v q

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The Life Insurance Puzzle
 Note that the first two terms in the FOC for insurance say that
the expected marginal utility of consumption now is negative
since insuring reduces dollars now for the individual and
significant other.
 The significant other, as beneficiary, receives dollars then in
the death event and so the last term in is positive.
 If the individual’s utility is increasing in that of the
significant other and the significant other’s expected marginal
utility of consumption then becomes unbounded as
consumption then goes to zero then some life insurance is
demanded.
 It is the last term in the FOC that is missing in the classic
paradigm or equivalently the purely selfish version of the
model.

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An Annuity Puzzle?
Consider the same movement from
investing in bonds to investing in
annuities that generated the puzzle
Dv H  D1 H  D2 H
  pb  pa  M  D3u D2v q
  pb  pa  pl  M

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Puzzle
Consider loading on the annuity contract
 1 1 q  q
pb  pa  pl     
1 r 1   1 r 
  1 r
 1 q 
 pb   1  q   
  1   
 
0

If there is no loading, i.e.,   0 then the


derivative in the annuitizing direction is zero.
If there is loading then the derivative is
negative
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Extensions of the New Paradigm
Financial Distress
◦ Annuity provider
◦ Insurer
Health Risks

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Financial Distress
Consider the risk of insolvency for the
annuity provider.
 How does this risk affect the demand for
annuities?
 If p is the probability of insolvency then p (1
– q) is the probability that the individual
survives and has an annuity that does not
provide the promised payment.
This changes the individual’s expected
utility.
 The demand for annuities is weakened
even without altruism.
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Health Risk
Consider an uninsurable health risk that
necessitates a medical expenditure now.
The wealth now becomes
w  L p
W 
 w 1 p
where L represent the expense now that
occurs with probability p. Also suppose that
the health risk does not affect the mortality
rate.
Suppose that the annuity is illiquid.
Such a health risk eliminates or reduces
the demand for annuities.
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Concluding remarks
The economic paradigm must be changed so
that the demand for life insurance can be
rationalized. This analysis does that.
This analysis provides the theoretical
foundation for the bequest motive.
There is no annuity puzzle in the new
paradigm.
Financial distress may weaken the annuity
demand.
A health risk may eliminate the annuity
demand.

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