What Do We Know About Annuitization Decisions?

• Author: Maria Alexandrova,Nadine Gatzert
• DOI: http://doi.org/10.1111/rmir.12115
• Date: 01 March 2019
• Published date: 01 March 2019

Risk Management and Insurance Review

C

Risk Management and Insurance Review, 2019, Vol.22, No. 1, 57-100

DOI: 10.1111/rmir.12115

FEATURE ARTICLE

WHAT DOWEKNOW ABOUT ANNUITIZATION

DECISIONS?

Maria Alexandrova

Nadine Gatzert

ABSTRACT

Against the background of aging societies and increasing life expectancies, the

protection of individuals from outliving their savings has become increasingly

relevant. Annuities represent insurance against longevity risk and can prevent

old-age poverty. The aim of this article is to present the current state of theo-

retical, empirical and experimental evidence with regard to annuitization deci-

sions. Towardthis end, we conduct a systematic literature review that includes

89 articles. Based on this, we study welfare effects of mandatory annuitization,

annuitization rates and the optimal fraction of wealth to be annuitized, as well

as determinants of retirees’ choice to annuitize and their impact on annuity

demand. Finally, we presentpossible solutions for overcoming the low uptake

of annuities based on its causes. One main result is that behavioral biases in

annuitization decisions particularly require considerably more theoretical re-

search and empirical evidence, and that theoretical models already appear to

well explain empirically observed annuitization rates.

INTRODUCTION

Annuitization of wealth to protect against longevity risk in retirement, and the under-

utilization of annuities in retirement planning is a universal challenge.1Life annuities

provide individuals with insurance against this longevity risk by guaranteeing a cer-

tain lifelong payment stream. Therefore, annuitization of preretirement wealth is one

of the main aspects of retirement to consider. However, the private annuity contracts

are argued to be rather rare (e.g., Modigliani, 1986; Benartzi et al., 2011). Against this

background, the aim of this article is to conduct a systematic literature review to gain a

better understanding of the decision-making process with respect to annuitization and

Maria Alexandrova is at the School of Business, Economics and Society, Friedrich-Alexander

University Erlangen-N¨

urnberg (FAU), phone: +49 (0) 911 5302 884; fax: +49 (0) 911 5302 888;

email: maria.alexandrova@fau.de. Nadine Gatzert is at the School of Business, Economics and

Society,Friedrich-Alexander University Erlangen-N ¨

urnberg (FAU),phone: +49 (0) 911 5302 884;

fax: +49 (0) 911 5302 888; email: nadine.gatzert@fau.de. The authors would like to thank two

anonymous referees for valuable comments on an earlier version of the paper.

1See Cummins and Venard(2008) and Ferguson (2014) for a review of global and local develop-

ments affecting the insurance business and the financial security in retirement.

57

58 RISK MANAGEMENT AND INSURANCE REVIEW

thus potential underinsurance against longevity risk during the retirement phase, along

with potential solutions.

Numerous academic and practitioner-oriented articles suggest various approaches to

determine the optimal fraction of wealth that has to be annuitized (e.g., Yaari, 1965;

Sinha, 1986; Mitchell et al., 1999; Davidoff et al., 2005; Davidoff, 2009; Lockwood, 2012;

Bommier and Le Grand, 2014; Horneff et al., 2014; Reichling and Smetters, 2015). Other

authors study actual annuitization rates (e.g., Dushi and Webb, 2004; Lockwood, 2012;

Cappelletti et al., 2013; Previtero, 2014; Banks et al., 2015; Hagen, 2015; Reichling and

Smetters, 2015) or investigate the determinants of the customer’s choice with respect

to purchasing life annuities (e.g., Williams, 1986; Brown, 2001, 2003; Brown et al., 2008;

Pang and Warshawsky, 2010; Benartzi et al., 2011; Chalmers and Reuter, 2012; Beshears

et al., 2014). Furthermore, several literature reviews addressthe problem of annuitization

decisions. For example, MacDonald et al. (2013) consider 100 articles in order to examine

the ways in which retirees do/could/should draw down their retirement savings, while

also pointing out conceptual and methodological weaknesses in the existing literature.

The authors do not explicitly focus on annuitization, but rather give an overview of

different strategies that are available for managing retirement wealth (annuitization,

self-management and hybrid strategies) and formulate general advice for retirees based

on individual and employment-related sources, as well as on the country of residence’s

tax and benefits transfer system. In addition, Benartzi et al. (2011) examined the phe-

nomenon of the annuity puzzle2in their literature review in order to identify the factors

that can explain its existence and develop policy proposals to stimulate annuity de-

mand, while Gatzert and Klotzki (2016) more specifically focus on factors that affect the

demand for and supply of enhanced annuities based on a literature review and an em-

pirical survey concerning the German market. Finally,Zietz (2003) studied the literature

on demand for life insurance in general.

In contrast to previous work, the contribution of this article is to provide a more com-

plete literature review and to offer solutions to the existing problem of underutilization

of annuities along with the directions for future research. In particular, we study the

decision-making process with respect to annuitization by explicitly distinguishing be-

tween the existing theoretical, empirical and experimental literature and by considering

three major aspects. We first focus on the starting point of the decision-making process

by evaluating the literature on mandatory annuitization and investigating its impact

on welfare from the individual’s and/or society’s perspective. Second, we review the

literature focusing on the decision about whether or not to annuitize and on the optimal

allocation of individual wealth among annuities and other sources of retirement in-

come. The third and main focus is to review the theoretical, empirical and experimental

evidence regarding factors that influence an individual’s decision to annuitize wealth,

along with possible solutions regarding potential underannuitization and directions for

future rese arch.

The article is organized as follows. “Systematic Literature Review: Methodology” section

presents the methodology. “Three Aspects of Annuitization Decisions” section offers the

2The term “annuity puzzle” describes a discrepancy between high annuitization rates predicted

by theoretical models and low annuity uptake, which is empirically observed (see, e.g., Benartzi

et al., 2011).

WHAT DOWEKNOW ABOUT ANNUITIZATION DECISIONS?59

findings with respect to three aspects of annuitization decisions, presents solutions for

overcoming the problem of underannuitization, and gives directions for future research.

“Summary and Implications” section summarizes the results.

SYSTEMATIC LITERATURE REVIEW:METHODOLOGY

To identify the current state of research regarding the three major aspects of annuitiza-

tion (mandatory annuitization; optimal fraction of wealth to be annuitized; drivers of

the annuitization choice), we conducted a systematic literature review based on journals

with a 5-year impact factor greater than 1 according to the ISI Web of Knowledge: So-

cial Science Journals (see, e.g., Gatzert, 2015). The subject categories included business,

finance, economics, political science, applied psychology,social sciences and mathemat-

ical methods. The search resulted in 330 journals.3After the filtration, the number of

journals was reduced to 168. As a next step, we conducted a search within the topic of the

article (contains title, abstract, and keywords) within the Web of Science database using

the following keywords: “annuitization”/“annuity puzzle”/“retirement AND portfo-

lio.” Further, we filtered the sample based on year of publication and language.4The

search resulted in 282 articles in the relevant journals. We next evaluated the abstracts

of the corresponding articles to see whether the problem of annuitization decisions

was directly addressed in the article, either using a theoretical framework, based on

an empirical sample (e.g., households, consumers), or by means of an experiment. This

resulted in 89 papers being included in the review.

THREE ASPECTS OF ANNUITIZATION DECISIONS

Using the methodology previously described, we reviewed theoretical, empirical and

experimental findings from the literature to investigate three important aspects of the

decision-making process with respect to annuitization. The first aspect concerns the im-

pact of mandatory annuitization on social and individual welfare, and mostly refers to

statutory and funded pensions (i.e., state- or employer-subsidized pension plans; see

Horneff et al. 2014), as the amount of social benefits, mandatory annuitization, regula-

tory requirements and other aspects of pension schemes are usually not under the direct

control of a single individual, but that of the state. The second aspect addresses the

optimal allocation of individual wealth for retirement, that is, to what extent annuities

should be included in the investment portfolio. The third aspect comprises all factors

that could influence annuitization choices, which can be grouped into three categories

3We excluded the journals with a research focus on topics that are not directly relevant for

decision-making, pension economics or retirement (with areas of research in agriculture, envi-

ronment, energy and resource economics; logistics and transportation; sports; banking, corpo-

rate finance and accounting; international and regional politics; and economic history). More-

over, we added several problem-relevant journals that were not included in the search results

but are frequently cited and contain relevant publications in our field of study: Journal of Mathe-

matical Analysis and Applications, Geneva Papers on Risk and Insurance,International Tax and Public

Finance,Issues and Practice,JournalofBehavioralFinance,Journal of Economic Policy Reform,and

North American Actuarial Journal.

4Only articles in English were taken into consideration. The chosen time interval was from 1965

to 2017, given that in 1965, Menahem E. Yaari’s fundamental article, “Uncertain Lifetime, Life

Insurance, and the Theory of the Consumer,” was published, which served as a trigger for

further research on the topic.