(UBS Pensions series 19) Are Annuities Value for Money? Who Can Afford Them?

This paper solves an empiricaly parameterized model of households’ optimal demand for nominal and inflation indexed annuities. The model incorporates mortality, inflation, and real interest rate risk.  The model draws some interesting predictions. First, the welfare calculations on the access to annuities markets show that nominal annuities are welfare improving even when sold at the empirically parameterized cost, which is above fair value. Real annuities are welfare improving over nominal annuities when sold at a fair price, but when we incorporate the empirically parameterized annuity premium the gains become negative at all wealth levels.  Second, the simulation of the model for the British population wealth distribution shows that an important explanation for the little interest in annuities comes from the fact that annuities are extremely expensive, compared with the total accumulated assets held by households. In other words many households can not afford even to enter the annuity market.  The paper also compares the simulated annuity demand to the actual demands reported in the Family Resources Survey. For those individuals who buy annuities, the simulated demands are not very different from those observed in the survey.