Dynamic Choice and Optimal Annuitization

Abstract

The optimal retirement income strategy is not a set of decisions made only upon retirement but a set of choices made throughout the retiree’s lifetime. In this article, a dynamic model is introduced where the level of annuitization both upon and during retirement, as well as the amount withdrawn from the portfolio, changes based on the retiree’s situation. This model, which better reflects the actual conditions and choices available to a retiree, results in a significant reduction in the optimal levels of annuitization, especially immediate annuitization upon retirement, when compared to static models. The costs associated with delaying the annuity decision are relatively small as long as the retiree implements a dynamic withdrawal strategy and starts to incorporate annuities by the tenth year of retirement. Overall, this analysis suggests that there is a significant potential benefit to retirees who implement dynamic strategies. Additionally, these dynamic strategies can result in an increase in certainty-equivalent wealth that is equivalent to an annual increase in risk-adjusted performance (i.e., alpha) of over 1.0% during retirement.

TOPICS: Retirement, fixed income and structured finance