Economics Seminar - Optimal Annuitization with Imperfect Information about Insolvency Risk

Even the highest-rated life-annuity providers have a non-zero probability of becoming insolvent during an annuitant's retirement, and many potential annuitants are unaware of the State Guaranty Associations which provide insurance against the associated financial consequences. We study the theoretical implications of insolvency risk---real and perceived---for optimal annuitization and welfare. Then, using a disciplined calibration of an otherwise-standard life cycle model, we show that even the modest risk of default associated with highly-rated providers reduces optimal annuitization and significantly reduces annuitant welfare, particularly for retirees with absent or modest bequest motives and relatively little or no pre-annuitized wealth. We further consider the implications for optimal annuitization and welfare of information frictions which prevent retirees from discerning true insolvency risk as they search for an annuity provider. We show theoretically how these frictions can further reduce optimal annuitization. In our calibrated life cycle model, we find that these frictions have plausibly large quantitative effects. Simulations of our model suggest that the general lack of awareness of the State Guaranty Association backstop by potential annuitants erodes a sizable fraction of the potential welfare benefits thereof.