Optimal Life Cycle Portfolio Choice with Variable Annuities Offering Liquidity and Investment Downside Protection

Published: 2013


We evaluate lifecycle consumption and portfolio allocation patterns resulting from access to Guaranteed Minimum Withdrawal Benefit (GMWB) variable annuities, one of the most rapidly-growing financial innovations over the last two decades. A key feature of these products is that they offer access to equity investments with downside protection, hedging of longevity risk, and partially-refundable premiums. Welfare rises since policyholders exercise the product’s flexibility by taking withdrawals and dynamically adjusting their portfolios and consumption streams. Consistent with observed behavior, differences across individuals’ cash out and annuitization patterns result from variations in realized equity market returns and labor income trajectories.

Key Findings

    • We devise a life-cycle consumption and portfolio choice model for an individual who — in addition to stocks and bonds — can gradually purchase fairly-priced deferred variable annuities with Guaranteed Minimum Withdrawal Benefits (GMWBs).
    • We show that investors optimally purchase measurable amounts of GMWBs well before retirement because of their flexibility and access to the stock market.
    • Policyholders will exercise this flexibility by taking withdrawals to adjust their portfolios and consumption streams. Nevertheless, at retirement, they also convert much of their accumulated amounts into additional annuities.
    • Heterogeneity analysis suggests that differences in individuals’ cash out and annuitization patterns result from variations in realized cumulative equity market return and labor income trajectories.