The Real Option to Delay Annuitization: It's Not Now-or-Never

Abstract

Asset allocation during the retirement years has not received as much attention as allocation prior to retirement. Within the context of financial planning towards the end of the life-cycle, the economics literature is puzzled over the extremely low levels of voluntary annuitization exhibited amongst the elderly. This phenomenon is inconsistent with a strict interpretation of the Modigliani life-cycle hypothesis. Although many plausible explanations have been suggested to reconcile theory and practice, none seem to contain any rigorous normative financial advice on when and if one should purchase an immediate annuity. This is particularly relevant given the increasing number of Defined Contribution pension plans in the U.S., within which the participants have to manage the risk of outliving their resources, and the corresponding trend away from Defined Benefit plans. In contrast to a classical economic approach - and motivated by the financial derivatives literature - this paper focuses attention on the Real Option embedded in the decision to annuitize. Indeed, a fixed immediate life annuity can be viewed as a project with a positive net-present value when compared to maintaining liquid wealth in non-annuitized assets. However, this project should nevertheless be deferred, since the option to wait and annuitize later has value. This result is driven by the higher possible risk-adjusted returns from alternative asset classes in the early stages of retirement, as well as possible asymmetries in mortality rates between subjective health status and objective annuity pricing. Practically speaking, we estimate that the real option to defer annuitization (RODA) is quite valuable until the mid-70s or mid-80s (depending on one's gender and risk aversion), at which point fixed immediate life annuities become the optimal asset class. Moreover, individuals with a higher risk tolerance and greater health asymmetry are endowed with an even larger option value to wait. However, low-cost variable immediate annuities, which are currently not widely available but which provide complete control over the asset allocation process within an immediate annuity wrapper, greatly reduce the option value to wait and create large welfare gains.