Till Death Us do Part: Liquidity and the Annuity Puzzle
By Barbara Summers & Robert Hudson
The annuity puzzle refers to the phenomenon that voluntary annuity take-up is typically much lower than predicted by mainstream economic models. Such models typically make strong assumptions regarding the risk and uncertainty facing individuals and neglect the role of liquidity. Often individuals are assumed to face only longevity risk or to have hedged all other risks in complete markets. In practice individuals need an element of liquidity in their portfolios to control the risks and uncertainty they face. We initially show that the gains from annuitization arise from there being a level of illiquidity in these products, without which the benefits of annuities could not be funded. Hence annuities cannot dominate liquid assets such as bonds in this vital dimension despite their other theoretical advantages. Subsequently we draw on the empirical literature investigating the market value of liquidity to show that the value investors place on liquidity may substantially explain the puzzle.
Source SSRN
