Life annuities and uncertain lifetimes.

• Author: Brown, Jeffrey R.
• Position: Research Summaries

As the baby boom generation begins the transition into retirement, concerns about retirement income security are rising in importance on the agenda of policymakers and academic researchers across the globe. Recent decades have witnessed many changes to the retirement income landscape, including the shift from defined benefit to defined contribution pension plans in the United States and the introduction of personal accounts as part of public pensions systems in dozens of other countries. A common theme in these changes has been a shift toward increased individual self-reliance in retirement planning.

While researchers and policymakers have placed enormous attention on the accumulation phase of retirement accounts, such as how individuals save and invest, they are becoming increasingly aware that asset accumulation is only part of the retirement security equation. The other part is how individuals convert their accumulated savings into a retirement consumption stream, particularly when most of us do not know how long we will live. Indeed, uncertainty about length-of-life is one of the most significant sources of financial risk facing today's retirees.

Dramatic advances in life expectancy over the last century mean that today's typical 65-year old man and woman can expect to live to age 81 and 85 respectively. Perhaps even more striking is the fact that almost a fifth of 65-year-old men and nearly one-third of 65-year-old women will live to age 90 or beyond. Without appropriate financial planning during retirement, increased longevity means that individuals face a greater risk of being forced to substantially reduce their living standards at advanced ages.

Life annuities are financial instruments that allow an individual to exchange a stock of wealth for a stream of income that continues for life. An annuity provider, such as an insurance company or the government, pools the resources of annuitants and uses the resources of those who die young to fund increased consumption for those who live a long time. Because of their ability to insure against the consumption uncertainty that arises from longevity risk, life annuities have played an important role in economic models of consumption for at least four decades, and recently have begun to attract considerable policy attention as well. This article provides a brief summary of the rapidly growing body of research dedicated to better understanding annuity markets in the United States and abroad.

Annuities in Economic Theory

In a seminal article published over four decades ago, Menachem Yaari incorporated lifespan uncertainty into a standard life-cycle consumption model. (1) He showed that a rational consumer with no bequest motives ideally would place all of his wealth into actuarially-fair life annuities instead of conventional bonds. My recent work with Tom Davidoff and Peter A. Diamond (2) extends this result by showing that, with complete markets, this full annuitization result holds in a much more general set of circumstances than originally believed. Indeed, many of the usual assumptions imposed on consumer preferences in standard economic models (exponential discounting, adherence to expected utility axioms, lack of habit formation) are unnecessary. Neither must annuities be actuarially fair, nor longevity risk the only source of consumption uncertainty. We further show that this result holds for annuities backed by risky assets as well as bonds, including variable annuities offered by private insurers such TIAA-CREF. All that is required is...