A critical review of 'optimal' annuitization strategies

Abstract

This paper is an analysis of different self-annuitization strategies advised to a retiree. At the time of retirement, an individual has the choice between annuitizing immediately with their wealth or delaying until a future date while making the most from returns earned through financial markets. This is a similar structure to how a Defined Contribution (DC) pension plan works. Various researchers have assisted retirees on this dilemma of whether or not to annuitize. They designed strategies that work under general market settings and any individual preferences that maximize the income generation. However, these studies assume that individuals are making decisions as if they are maximizing or behaving optimally. In reality, what might be ``optimal" in a general sense may not match the optimality defined in a normative sense of giving advice. The effect of the gap between the prescribed and descriptive nature of this advice is not well discussed in the current literature.

Our motivation comes from examining the prescriptive nature of the strategies with respect to downside risk. In this paper, we choose three different self-annuitization strategies, from three different papers: Milevsky (2001), Milevksy and Young (2007) and Giacinto and Vigna (2012). The strategies proposed in these papers provide normative advice to retirees on if and when to annuitize in retirement years. While an attempt is made to minimize the risk of outliving their own assets and maximize the risk-reward trade-off. The main concern should be the elicited risk in adopting these strategies and doing poorly. In the retirement years, it could be more catastrophic to an individual if he/she runs out of money by following the normative solutions proposed through these strategies. For an average retiree who has limited financial literacy or deteriorating cognitive abilities, it is highly challenging to have their future secured without the fear of inadequate income. Thus, we use risk measures to review the given literature on various plausible explanations of their working strategy and assess the risk of compromising income security. We implement modern world parameters into these strategies to assess if they are truly delivering sound advice.