Cumulative Prospect Theory, Deferred Annuities and the Annuity Puzzle

During the past few decades, there has been a steady shift from traditional defined benefit (DB) pension plans to defined contribution (DC) pension plans. In a DC pension plan, retirees have to make decisions on how to spend their accumulated retirement funds. Although it has been proved theoretically that annuities can provide optimal consumption during one's retirement period, retirees' reluctance to purchase annuities is a long-standing puzzle. Cumulative Prospect Theory (CPT), which considers both loss aversion and a probability transformation, can explain the low demand for immediate annuities during retirement. It also shows that retirees would be willing to buy a long-term deferred annuity at retirement. By considering each component in CPT, we find that loss aversion is the major reason that stops people from buying an annuity, while the survival rate transformation is an important factor affecting the decision of when to receive annuity incomes