Why are annuities not voluntarily taken up by a larger number of retirees? In the individual consumption/savings portfolio choice literature, a very important participation puzzle arises from the revealed preference of households not to voluntarily buy annuities at retirement, despite the strong theoretical reasons that point towards high demand for these products. Specifically, as early as 1965, Yaari demonstrates that risk aversion is sufficient to induce a household to buy an actuarially fair annuity as protection against life expectancy risk. Yet, despite this strong theoretical result, annuity demand remains very low in the data, what is known as the "annuity market participation puzzle".
It is important to understand why this puzzle arises from a theoretical perspective but there is also another, equally strong, empirical reason to explain the puzzle. Specifically, there has been a large shift in pension provision from defined benefit (DB) to defined contribution (DC) plans both in the U.S. and in the U.K.. DB plans offer not only a fixed monthly payment but also offer it for life, therefore providing a natural insurance for life expectancy risk. On the other hand, DC plans place the decision of how fast to decumulate during retirement in the hands of the individual. As a result, the issue of annuity provision could become very important for financial planning after retirement.
Understanding this puzzle has generated a large number of recent papers that have attempted an explanation. Potential explanations involve the lack of actuarially fair annuities, inflation risk, a strong bequest motive, habit formation in references, the presence of some annuitization through state social security and private DB plans, the presence of uncertain medical expenditures, non actuarially fair annuity provision and minimum annuity size purchase requirements, rare events, and flexibility. Overall, however, the current conventional wisdom, as reiterated by Davidoff, Brown and Diamond (2005), treats the limited voluntary annuity market participation as a puzzle that remains to be explained.
Nevertheless, very few studies have attempted to empirically analyze the determinants of voluntary annuity market participation at the household level. What are the characteristics of households that participate (or not) in this market? Understanding the factors affecting the participation decision can potentially help us quantify the magnitude of the puzzle relative to the predictions from different models of economic behavior. In this paper we begin by investigating empirically the determinants of household annuity market participation in the U.K. voluntary annuity market.
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How Deep is the Annuity Market Participation Puzzle?
