Annuity – a financial product which provides a lifelong return to the its holder called the annuitant. Unlike stocks, annuities can be bought from the insurance companies; however, unlike price of stocks which is determined through demand and supply, the price of an annuity depends upon various factors like the age of the purchaser and the return it is paying out to the annuitant. People who desire cash inflows during their retirement age prefer annuities as they provide a lifelong stream of cash flows and minimize the dependency of older individuals on social security benefits. However, the price of an annuity is often a concern to people who demand annuities. Since the price depends upon the age of the buyer, charging a fair price is an issue and an imperfection in the insurance market (Sheshinski, 2007). As baby boomers are aging and reaching their retirement age, there is an increasing concern on the secure retirement age and thus there is an increasing debate on the advantages and imperfections which exist in the annuity markets. This paper analyzes the advantages and disadvantages of using annuity as a social security tool.
Before we discuss the advantages of annuities, it is important to
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Imperfections due to inappropriate pricing
The prices of annuities are determined by the age of the annuitant i.e. longer the expected age of the buyer, higher the price of the annuity. However, expected life is a very unreliable measure/determinant of price. In USA, the average expected age is 77.7 years and people currently at the age of 65 are expected to live for another 18 years. (Brown, 2004) Though it looks great but it is the expected age and the actual age may vary drastically. People may die suddenly due to accident or any natural disaster, right after the buy the annuity. Here comes in the imperfections as it is unfair for people that the pay more for a benefit which they never get a chance to enjoy.
Inflation uncertainty Interaction of asset market and longevity risk
Another argument which the opponents claim is that annuities give fixed nominal returns, however, in real terms, the return is decreasing as inflation tends to increase over time. Secondly, if the annuitant survived for a longer time, then the real returns will be even lesser and thus will not contribute in the maintenance of the same life style as the annuitant expects.
Arguments in favor of Annuity
Now that we know the arguments posed by opponents, it will be easier to defend our case as annuities are of growing debate in the American markets these days. There are various arguments which will prove that annuity is though the optimal solution for
Complete Annuitization is of Greater Value to the Consumers The extents of benefits of annuitization, varies from customer to customer, however, there a benefits for everyone, assuming there is no uncertainty. An economist, Yarri conducted a study and considered the process of annuization in a continuous time where consumers are not sure about the date of their death. However simple results were obtained by dividing time into tow periods – period 1 and period 2. Period 1 is when the consumer is definitely alive and period 2 is when the probability of a person’s survival is denoted by 1-q. (Diamond, 2005) The results showed that the benefits are greater for consumers whose expenditure is greater in for consumers whose expenditure is greater in period 1 then in period 2 i.e. consumers who spend more during there lifetimes are better off then people who do not spend at that time. Here it means that people who do not spend are likely to save and not invest. Not investing will lead to an uncertain old age where individuals will have to rely on social security benefits. By relying on annuity, people can have a secure old age.
Welfare Gains from Annuitiztion
It is a fact that individuals are utility maximizes and risk averse, thus they will rely on an investment that gives them constant and continuous returns especially those investors who wish to invest in a long term investment. In this context, utility derived from an investment depends upon the standard of living i.e. utility is a function of current and past consumption. Peter A. Diamond in his paper gave a derivation of the welfare gains which result from the use of annuity.
There have been important advances in the field of economics and annuity and its implications on the society are evident in economic literature, however, the current size of annuity market is still very small. Even the literature which supports annuitization is based on a number of assumptions and these assumptions need to be relaxed to get a better understanding of the benefits if this financial product. Therefore it is important that the economists must continue research in this area and improve the understanding of people regarding annuity. Surely, once the people will get to know the advantages of this financial product, its market is likely to grow for conscious baby boomers and successive generations.
Brown, J. R. (2004, March 22). Life annuities and uncertain lifetimes. Retrieved May 12, 2010, from AllBusiness: www.allbusiness.com
Diamond, P. A. (2005). PENSIONS FOR AN AGING POPULATION. Massachusetts Avenue, Cambridge: NATIONAL BUREAU OF ECONOMIC RESEARCH.
Peter A. Diamond. (2003). ANNUITIES AND INDIVIDUAL WELFARE. Cambridge: NATIONAL BUREAU OF ECONOMIC RESEARCH.
Sheshinski, E. (2007). The Economic Theory of Annuities. Princeton University Press.
Thomas Davidoff, P. A. (200). ANNUITIES AND INDIVIDUAL WELFARE.