Why the Deferred Annuity Makes Sense

Abstract

Although researchers have shown that purchasing longevity insurance at retirement guarantees pensioners of a high annual income for the rest of their lives, most retirees (who have a choice) choose to take the lump sum and self-manage the portfolio. This is a long-standing puzzle called the "annuity puzzle". This question arises in importance due to the UK government's recent changes in pension policy. This paper implements a behavioural model, the hyperbolic discount model, to analyse annuity purchase decisions. We give an explanation for the low demand of immediate annuity at retirement, and uncover the high desirability of long-term deferred annuities for both retirees and working-age pensioners. Based on our modeling result, a 65-year-old individual would like to pay 24% higher than the fair price for a 30-year deferred annuity. Moreover, we suggest that if governments were to introduce a pre-commitment device which requires pensioners to make annuitisation decisions 10 years before retirement, the take up rate of annuities would become higher.