As a preliminary foray into this question, the optimal portfolio allocations can be recalculated assuming the agent receives $11 000 of his preferred
$20 000 floor through the full age pension. The results are summarized in Table 7.3, illustrating the increasing exposure to risky assets that a universal age pension could potentially allow. Exposures almost double over the life expectancy horizon, more than double over a 25-year horizon and increase by about ten times for the 40-year timespan. A small publicly provided lifetime annuity can substantially increase optimal risky asset weights.
Even an endowment of $500 000 has not given the representative agent much freedom to invest outside the bond market because of the demands of guarding the consumption floor. By comparison, recall that the average expo- sure to risky assets of an allocated pension account is around 50–55 per cent.
Observed investment patterns in allocated pension accounts suggest that many retirees either rely on the age pension safety net, have ‘safe assets’ stored in other places (e.g. bank accounts), display some myopia, or are persuaded by advisers to hold more aggressive portfolios than may be in their best interest.
Since protecting oneself from longevity and investment risk places such stringent restrictions on portfolio allocations and consumption paths, these simulations could be used to make a prima facie case for annuitization.
However, a developing area of research on the best time to annuitize (Milevsky and Young 2002, 2003) has demonstrated that immediate full annu- itization is not always an optimal strategy. We re-evaluate the Milevsky–Young analysis for the HARA case.
environment it often pays to delay investments that cannot easily be reversed.
Using a Merton (1969) continuous time model with constant relative risk aver- sion, Milevsky and Young show that, for retirees constrained to make a complete and irreversible switch into a life annuity, the best age to annuitize may be well into retirement.
Advantages to delaying annuitization in their model arise from the possi- bility that higher returns in future periods will improve the budget constraint of the retiree, providing an enhanced stream of income after annuitization.
Moreover, by explicitly modeling the annuitant’s subjective knowledge of their own mortality as against the annuity provider’s objective assessment, Milevsky and Young are able to show that people who expect to live either longer or shorter lives than implied by the objective standard will have cause to delay annuitization. Annuitants who anticipate longer lives will build up their wealth in the risky environment and take advantage of the progressive falls in the price of life annuities as they age. Annuitants who anticipate shorter lives find the objectively priced annuities expensive, and avoid them for longer. These results appear to be both surprising and general.
Annuitization with a Consumption Floor
In the event that the potential annuitant and the annuity provider agree about the prospects of survival, the date of annuitization for a CRRA (zero-floor) agent is determined by comparing the returns to the risky asset (the Sharpe ratio) with the benefits of the certain income stream offered under the annuity.
The investor’s tolerance for risk, survival prospects and expectations of asset returns are all factors in the decision.
If the agent prefers to insure a floor level of consumption, the advantages to delaying annuitization are weakened. The full analysis of the HARA case is set out in Kingston and Thorp (2004), but the intuition can be summarized in Figure 7.6. For brevity, attention is restricted to the case where utility is defined as the log of the difference between actual consumption and floor consumption, corresponding to Milevsky and Young (2002), Appendix D and analogous to the g= 0 case in our simulation model. The Sharpe ratio of 0.18 corresponds to the assumptions made earlier in the text.
As the agent ages, the probability of dying (symbolized here as l) rises.
This increasing force of mortality makes annuity prices more favourable over time. It is not until lis sufficiently high that the agent will finally and irre- versibly close out the prospect of increasing wealth via the risky asset, and make the switch into annuities. By contrast, the HARA retiree is already protecting all future subsistence consumption in escrow wealth, and thus holds a smaller proportion of total wealth in the equity portfolio than the agent with a zero floor. Lower exposure to the potentially high-yielding risky asset
reduces the option value of delaying annuitization proportionately.
In this way, introducing a positive consumption floor has a similar effect to raising relative risk aversion. In addition, the agent recognizes that it costs less to store escrow wealth in an annuity rather than a bond portfolio over an infi- nite horizon, thus creating another incentive to switch into complete annuiti- zation at an earlier date.
Table 7.4 shows the optimal time to annuitize with and without insured consumption. (At 50 per cent insured consumption, the HARA agent displays relative risk aversion of two; at zero insured consumption, the RRA is one.)
There are two key observations to make here. First, the combination of a conservative forward-looking Sharpe ratio and a 50 per cent consumption
Finance for Australian annuitants 141
Table 7.4 Optimal age at annuitization, male (female)
Zero insured consumption 50% insured consumption
Sharpe ratio RRA=1 RRA=2 RRA=2
0.18 70.9 (76.1) 64.1 (70.3) 64.1 (70.3) 0.30 80.9 (84.6) 74.1 (78.8) 74.1 (78.8)
Notes: The Sharpe ratio of 0.18 obtains for the main capital-market parameter values assumed earlier in this chapter, namely, α= 0.06, r= 0.03, and σ= 0.17. The Sharpe ratio of 0.30 obtains for the capital-market parameters assumed by Milevsky and Young (2002), namely, α= 12, r= 0.06, and σ= 0.20. Modal and scale parameters of the Gompertz distribution were, for males (females) b= 9.78 (8.35) and m= 88.95 (92.76).
Force of mortality, λ, opportunity cost of annuitization
Age at annuitization Zero insured consumption at annuitization 50% insured consumption at annuitization 1/2[(0.18)2]
1/3[(0.18)2]
0 64.1 70.9
Force of mortality, λ
Figure 7.6 Optimal age at annuitization with and without a consumption floor
floor causes any advantage in delayed annuitization to vanish for males and to shrink to about five years for females. Not so, however, if choices are guided by an optimistic ‘historical’ assumption for the Sharpe ratio, linked to the high returns to equity that were recorded during the twentieth century in the USA, Australia, and a handful of other countries (Jorion and Goetzmann 1999).
Following Milevsky and Young,7and using the higher Sharpe ratio, raises the optimal delays to almost ten years for men and 14 years for women. Second, optimistic estimates of survival probability will also delay annuitization.
Actual immediate annuity prices in Australia match up reasonably well to the calculations in Table 7.4. Quotes for a $100 000, consumer-price-indexed immediate life annuity for a 65-year-old female (with a ten-year guarantee) offer initial income of $4892.8Assuming a risk-free real interest rate of 3 per cent, this quote implies (from the purchaser’s perspective) an average life expectancy for female annuitants of around 97 years, representing a discount- ing of population mortality estimates in the order of 55–60 per cent. This is consistent with the parameters underlying Table 7.4.
CONCLUSIONS
In this chapter we have sketched the current market for retirement income stream products in Australia and constructed some numerical experiments which shed light on optimal investment and annuitization strategies, consider- ing these questions within a HARA framework. One advantage of this approach is that it focuses on the protection of a floor level of consumption rather than a general distaste for risk, and thus meshes well with practitioner and policy-based measures of welfare in retirement.
Out of the array of immediate annuity and allocated pension products currently available, Australian retirees have preferred the allocated pension, a product which gives the retiree the most flexibility and the least insurance against investment and longevity risk. Recent survey data indicate that, on the one hand, allocated pensioners manage their accounts conservatively, drawing down balances quite slowly, while on the other hand choosing a 50–55 per cent average exposure to risky assets.
This degree of risk exposure may be at odds with securing a sufficiently long minimum consumption rate, since simulation experiments outlined here suggest that conservative portfolio allocations are necessary to guarantee an income stream as low as $20 000 past life expectancy. The insurance role of the age pension is one possible explanation for annuitants’ portfolio choices.
More optimistic views on prospective returns and risks to shares are another.
Both candidate explanations deserve attention in future research.
These issues raise the well-documented but puzzling reluctance of annui-
tants to take up life annuities. We extend recent work by Milevsky and Young (2002, 2003) by investigating whether the optimal time to annuitize is brought forward or delayed for agents who want to protect a positive consumption floor. The extra burden of annuitizing the consumption floor brings forward the switch to a life annuity.
NOTES
1. The authors would like to acknowledge the helpful comments of Henry Jin, Robert Kohn, Sachi Purcal, Tony Richards and Mike Sherris.
2. A proportion of the Australian workforce receives occupational pensions in retirement under the terms of defined benefit superannuation schemes. Most of the discussion to follow focuses on members of defined contribution schemes for whom annuitization is voluntary.
3. ETPs are specific categories of lump-sum payments made at termination of employment or from superannuation funds or retirement savings accounts, which receive special tax treatment.
4. More recently, the habit formation literature has generalized the idea of relative utility by allowing the consumption floor to vary over time according to an internal or external refer- ence path. See Constantinides (1990) or Campbell and Cochrane (1999) for examples.
5. The hyperbolic absolute risk aversion model, with a fixed consumption floor, is a time- separable special case of the habit persistence models. Merton (1971 and 1990) describes the portfolio allocation properties of this model in continuous time.
6. See Ingersoll (1987) and Campbell and Viceira (2002) for similar analysis.
7. The Milevsky–Young Sharpe ratio is based on Ibbotson Associates data, and their estimate of the Gompertz parameters were fit to Annuity Mortality table IAM2000 with projection scale G (see Milevsky and Young 2002, Table 1a, p. 23).
8. As quoted for AMP Life, Personal Investor, August 2003, p. 104.
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