Ebook A Dynamic Model of Nominal and Inflation-Indexed Annuities
Currently, and in most countries, the government, through the social security system, insures retirees against inflation and longevity risk. At retirement, the state pension that each retiree is entitled to receive is computed based on his lifetime earnings. The retiree is entitled to receive this pension for as long as he lives, and in this way obtains insurance against longevity risk. In addition, and in most countries, nominal state pensions are indexed to a measure of consumer prices such as the consumer price index (CPI), so that the real purchasing power of retirees is relatively unaffected by inflation movements.
In recent years, economists and politicians in most Western European countries have become increasingly worried with the sustainability of the current social security system and its current level of benefits. The ageing of the population has led to a dramatic and unsustainable increase in liabilities. Unsurprisingly, governments have started to reduce the level of benefits and have warned the public not to rely too much on state pensions for their consumption when old. Some governments have also provided tax incentives for households to save for their retirement (for example ISA’s in the United Kingdom).
However, accumulated financial wealth that is run down at retirement may not be a good alternative to state pensions, because it lacks some of the insurance features of the latter. A portfolio of financial assets does not necessarily provide insurance against inflation risk and longevity risk. Whereas in certain countries retirees may invest their financial portfolio in inflation-indexed bonds and in this way insure themselves against inflation risk, it may be harder to obtain insurance against longevity risk.
As demonstrated in the pioneering work of Yaari (1965), the optimal choice of a non-altruistic individual is to annuitize all his assets, whenever the probability of death is positive. This result is driven by the fact that the annuity system reduces the inefficiency created by the uncertainty of the time of death, as well as the fact that actuarial notes pay a higher interest (market interest rate plus a mortality premium) conditional on being alive.
Applying this result, individuals would use their accumulated financial wealth to purchase an annuity upon retirement. If the annuity is inflation-indexed it will insure the retiree against inflation movements in addition to longevity risk. Annuities are offered in the private marketplace in many countries, including the United Kingdom. Thus, it seems, the features of state pensions may be replicated in the marketplace, at some cost, for households that wish to do so.
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PDF Ebook A Dynamic Model of Nominal and Inflation-Indexed Annuities
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