Asset Allocation, Longevity Risk,

Annuitisation and Bequests

Dr. David Schiess, B. Sc.

Group for Mathematics & Statistics

Bodanstrasse 6, 9000 St. Gallen, Switzerland
david.schiess@unisg.ch
www.mathstat.unisg.ch

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 1/24
 Outline

Outline
● Outline
■ Motivation
Motivation
■ Model Assumptions
Assumptions ■ Optimisation Problem
Optimisation Problem
■ Results
Results
■ Conclusions
Conclusions

Thanks

Back-up

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 2/24
 Relevance

Outline ■ Importance of the End of the Life-Cycle:

Motivation ◆ Rising Conditional Life Expectancies
● Relevance
● Technical Problem ◆ Growing Number of DC Plans
● Literature
● Extensions ◆ Continuing Wealth Concentration Among Pensioners
Assumptions ◆ Input for Labour Models
Optimisation Problem

Results

Conclusions

Thanks

Back-up

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 3/24
 Technical Problem

Outline ■ Technical View of the Pensioner’s Problem:

Motivation ◆ Consumption/Portfolio Optimisation (c, π)
● Relevance
● Technical Problem → Financial Market Risk
● Literature
● Extensions ◆ Optimal Annuitisation Decision (τ )
Assumptions → Longevity Risk
Optimisation Problem ■ ⇒ Combined Optimal Stopping and Optimal Control
Results
Problem (COSOCP)
Conclusions

Thanks

Back-up

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 4/24
 Literature

Outline ■ Literature Overview:

Motivation ◆ Merton (1969) → Stochastic Control
● Relevance
● Technical Problem ◆ Vast Literature Imposing a Fixed or Infinite Planning
● Literature
● Extensions Horizon
Assumptions ◆ Yaari (1965) → Uncertain Lifetime
Optimisation Problem ◆ Richard (1975) → Reversible Annuities
Results ■ Few Normative Models with Irreversible Annuities and
Conclusions
Uncertain Lifetime, i.e.
Thanks ◆ Milevsky and Young (2007):
Back-up Commitment to Predetermined Annuitisation Time
◆ Stabile (2006):
Annuitisation Rule as a Controlled Stopping Time

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 5/24
 Extensions

Outline ■ Our Extensions to the Model of Stabile (2006):

Motivation ◆ Inclusion of a Bequest Motive
● Relevance
● Technical Problem ◆ Prior Life Insurance and Subsistence Level of Bequest
● Literature
● Extensions ◆ Economically Relevant Risk Aversion (γ > 1)
Assumptions ◆ New Solution Method with Duality Arguments
Optimisation Problem

Results

Conclusions

Thanks

Back-up

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 6/24
 Model Assumptions

Outline ■ Utility Maximisation (Consumption, Annuity, Bequest;

Motivation
Identical Relative Risk Aversion)
Assumptions
● Model Assumptions
■ No Stochastic Income
Optimisation Problem → No Labour Income
Results ■ Prior Decision on Annuitisation and Life Insurance Taken as
Conclusions Given
Thanks ■ Annuitisation of Entire Wealth and Consumption of Entire
Back-up
Annuity
■ One Riskless Asset, One Risky Asset (Geometric Brownian
Motion)
■ Exponential Mortality Law

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 7/24
 Indirect Utility

Outline
Total Expected Discounted Utility Jc,π,τ (w):
Motivation
T
Assumptions Zx    
S W (τ )
Optimisation Problem E  e−δ t U1 (c (t)) 1{t≤τ } + U2 1{t>τ } dt
● Indirect Utility āx+τ
● COSOCP
0
● Verification Theorem
● Variational Inequality S
i
+ηe−δ Tx
U3 (W (Tx ) + Z s ) 1{Tx ≤τ } + U3 (Z s ) 1{Tx >τ }

Results

Conclusions

Thanks

Back-up

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 8/24
 COSOCP

Outline
General COSOCP with Exponential Mortality:
Motivation

Assumptions V (w) = sup Jc,π,τ (w) for all w > 0

(c,π,τ )∈G(w)
Optimisation Problem
● Indirect Utility
● COSOCP
τ 
● Verification Theorem
Z
w −β S t −β S τ
● Variational Inequality
Jc,π,τ (w) = E e f (c (t) , W (t)) dt + e g (W (τ ))
Results
0
Conclusions

Thanks

Back-up
dW (t) = W (t) [r + π (t) (µ − r)] dt−c (t) dt+σπ (t) W (t) dB (t)

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 9/24
 Verification Theorem

Outline ■ Optimal Strategies:

Motivation ◆ Annuitisation rule
Assumptions

Optimisation Problem τ ∗ = inf {t ≥ 0|W ∗ (t) ∈

/ D}
● Indirect Utility
● COSOCP
● Verification Theorem with
● Variational Inequality
D = {W (t) ∈ G | v (W (t)) > g (W (t))}
Results

Conclusions
◆ Consumption rule
Thanks
c∗ = I (vW (W ∗ (t))) 1{t≤τ ∗ }
Back-up

◆ Investment rule
∗ µ−r vW (W ∗ (t))
π =− 2 ∗ ∗
1{t≤τ ∗ }
σ W (t) vW W (W (t))

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 10/24
 Variational Inequality

Outline ■ The Verification Theorem Reduces the COSOCP to the

Motivation
Variational Inequality:
Assumptions

Optimisation Problem max {Lcom v (W (t)) , g (W (t)) − v (W (t))} = 0 for W (t) > 0
● Indirect Utility
● COSOCP
● Verification Theorem with
● Variational Inequality
com
f (c (t) , W (t)) − β S v (W (t)) + Lv (W (t))

Results L v (W (t)) = sup
Conclusions
(c,π)∈G τ (W (t))

Thanks
■ subject to
Back-up

v (W (t)) = g (W (t)) for all W (t) ∈ ∂D

■ and
vW (W (t)) = gW (W (t)) for all W (t) ∈ ∂D.

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 11/24
 No-Bequest Case

Outline
■ Now-or-Never Annuitisation: M nb
Motivation
■ Natural Parameter Effects
Assumptions
◆ Risk Aversion (A+)
Optimisation Problem
◆ Subjective Life Expectancy (A+)
Results
● No-Bequest Case ◆ Objective Life Expectancy (A−)
● Bequest Case γ < 1
● Bequest Case γ > 1
◆ Identical Life Expectancy (A−)

Conclusions
◆ Sharpe Ratio (A−)

Thanks ■ Annuitisation in Most Parameter Settings

Back-up → Important Inclusion of a Bequest Motive

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 12/24
 Bequest Case γ < 1

Outline ■ Bequest Case γ < 1 and Z s = 0:

Motivation ◆ Now-or-Never Annuitisation: M b = M nb + λS η
Assumptions ◆ Slight Tendency for the Financial Market
Optimisation Problem
→ Important Inclusion of Bequest Motive
Results ◆ Natural Parameter Effects
● No-Bequest Case
● Bequest Case γ < 1 ◆ Natural Comparison to No-Bequest Case
● Bequest Case γ > 1
cb cnb
Conclusions
■
Wb
< W nb
b
Thanks
■ W > W nb
b
■ π = π
nb
Back-up
cb
■
Wb
decreases in η

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 13/24
 Bequest Case γ > 1

Outline ■ Bequest Case γ > 1 and Z s > 0:

Motivation ◆ Never Annuitisation or Wealth-Dependent Annuitisation
Assumptions
with D = (W , ∞)
Optimisation Problem ◆ Natural Comparison to No-Bequest Case
Results ◆ Real COSOCP with D = (W , ∞):
● No-Bequest Case
● Bequest Case γ < 1 ■ Simplification via Duality Arguments
● Bequest Case γ > 1
■ Free Boundary Value Problem
Conclusions
■ Numerical Solution Algorithm
Thanks
→ Boundaries
Back-up
→ Value Function
■ Natural Parameter Effects:

→ Life Insurance (A+)

→ Bequest Motive (A−)
■ Heavy Consumption Smoothing

■ More Aggressive Investment Rule Compared to Merton

→ Additional Option of Annuitisation

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 14/24
 Conclusions

Outline ■ Conclusions:
Motivation ◆ COSOCP: New Solution Method
Assumptions ◆ Economically Important Risk Aversion γ > 1
Optimisation Problem ◆ Longevity Risk Is Absolutely Relevant
Results → Modelling of Lifetime
Conclusions
● Conclusions
→ Role of Pension Funds
◆ Essential Inclusion of a Bequest Motive
Thanks
→ Consumption-Wealth Trade-off
Back-up
→ Absurd Strong Tendency for the Annuity Market
Vanishes

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 15/24
 Thanks

Outline
Thank you very much for your attention!
Motivation

Assumptions

Optimisation Problem

Results

Conclusions

Thanks
● Thanks

Back-up

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 16/24
 Indirect Utility (2)

Outline
Indirect Utility Function with Exponential Mortality:
Motivation
τ
Assumptions
Z
S 
w −βx t
Optimisation Problem E e U1 (c (t)) + λSx ηU3 (W (t) + Z s ) dt
Results 0
Conclusions
#
S
−βx τ 1  O


S s
Thanks +e U2 W (τ ) r + λ x + λ x ηU3 (Z )
Back-up
βxS
● Indirect Utility (2)
● Continuation Region
● Investment in the Bequest
Case γ > 1
● Consumption in the Bequest
Case γ > 1
● References (1)
● References (2)
● References (3)
● References (4)

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 17/24
 Continuation Region

Outline ■ Continuation Region D

Motivation
→ Open and Connected
Assumptions
■ U ⊂ D with
Optimisation Problem

U = W (t) ∈ R+ | Lcom g (W (t)) > 0

Results

Conclusions

Thanks ■ The set U can be used to infer information about the form of
Back-up the important continuation region D.
● Indirect Utility (2)
● Continuation Region
● Investment in the Bequest
Case γ > 1
● Consumption in the Bequest
Case γ > 1
● References (1)
● References (2)
● References (3)
● References (4)

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 18/24
 Investment in the Bequest Case γ > 1

Outline

Motivation

h = 0 .2 5
Assumptions
h = 0 .5
Optimisation Problem h = 1
Results
M e rto n

Conclusions

Thanks

Back-up
● Indirect Utility (2)
● Continuation Region
● Investment in the Bequest
Case γ > 1
● Consumption in the Bequest
Case γ > 1
● References (1)
● References (2)
● References (3)
● References (4) Figure 1: The investment rule for different values of the bequest
parameter assuming a subjective and objective life expectancy of
20 years, a subjective and objective discounting parameter of 0.035,
µ = 0.08, σ = 0.2, life insurance net of subsistence of 500 and γ = 2.

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 19/24
 Consumption in the Bequest Case γ > 1

Outline

Motivation

Assumptions
h = 0 .2 5
h = 0 .5
Optimisation Problem h = 1
Results
M e rto n (n o -b e q u e s t)

Conclusions

Thanks

Back-up
● Indirect Utility (2)
● Continuation Region
● Investment in the Bequest
Case γ > 1
● Consumption in the Bequest
Case γ > 1
● References (1)
● References (2)
● References (3)
● References (4)
Figure 2: The consumption fraction for different values of the bequest
parameter assuming a subjective and objective life expectancy of 20
years, a subjective and objective discounting parameter of 0.035, µ =
0.08, σ = 0.2, life insurance net of subsistence of 500 and γ = 2.

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 20/24
 References (1)

Outline
[1] G. A. Akerlof, The Market for Lemons: Quality Uncertainty
Motivation
and the Market Mechanism, Quarterly Journal of
Assumptions
Economics 84 (1970) 488-500
Optimisation Problem
[2] R. T. Baumann and H. H. Müller, Pension Funds as
Results
Institutions for Intertemporal Risk Transfer, Insurance:
Conclusions
Mathematics and Economics (2008)
Thanks

Back-up
[3] N. Charupat and M. A. Milevsky, Optimal Asset Allocation
● Indirect Utility (2)
● Continuation Region
in Life Annuities: A Note, Insurance: Mathematics and
● Investment in the Bequest
Case γ > 1
Economics 30 (2002) 199-209
● Consumption in the Bequest
Case γ > 1 [4] M. D. Hurd and K. McGarry, Evaluation of the Subjective
● References (1)
● References (2) Probabilities of Survival in the Health and Retirement
● References (3)
● References (4) Study, Journal of Human Resources 30 (1995) 268-291
[5] M. D. Hurd and K. McGarry, The Predictive Validity of
Subjective Probabilities of Survival, NBER Working Paper
6193 (1997)

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 21/24
 References (2)

Outline
[6] N. Hakansson, Optimal Investment and Consumption
Motivation
Strategies under Risk, an Uncertain Lifetime, and
Assumptions
Insurance, International Economic Review (1969)
Optimisation Problem
[7] R. C. Merton, Lifetime Portfolio Selection under
Results
Uncertainty: The Continuous-Time Case, Review of
Conclusions
Economics and Statistics 51 (1969) 247-257
Thanks

Back-up
[8] R. C. Merton, Optimum Consumption and Portfolio Rules in
● Indirect Utility (2)
● Continuation Region
a Continuous-Time Model, Journal of Economic Theory 3
● Investment in the Bequest
Case γ > 1
(1971) 373-413
● Consumption in the Bequest
Case γ > 1 [9] M. A. Milevsky, K. S. Moore and V. R. Young, Asset
● References (1)
● References (2) Allocation and Annuity-Purchase Strategies to Minimize the
● References (3)
● References (4) Probability of Financial Ruin, Mathematical Finance 16(4)
(2006) 647-671

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 22/24
 References (3)

Outline
[10] M. A. Milevsky and V. R. Young, Annuitisation and Asset
Motivation
Allocation, Journal of Economic Dynamics and Control
Assumptions 31(9) (2007) 3138-3177
Optimisation Problem
[11] B. ∅ksendal, Stochastic Differential Equations, Springer,
Results
Berlin (2003)
Conclusions

Thanks
[12] S. F. Richard, Optimal Consumption, Portfolio and Life
Back-up
Insurance Rules for an Uncertain Lived Individual in
● Indirect Utility (2)
● Continuation Region
Continuous Time Model, Journal of Financial Economics 2
● Investment in the Bequest
Case γ > 1
(1975) 187-203
● Consumption in the Bequest
Case γ > 1 [13] D. Schiess, Consumption and Portfolio Optimisation at the
● References (1)
● References (2) End of the Life-Cycle, Doctoral Thesis, University of St.
● References (3)
● References (4) Gallen, Switzerland
[14] D. Schiess, Optimal Strategies During Retirement, Center
for Finance Working Paper No. 70, University of St. Gallen,
Switzerland

David Schiess, 27th of March 2008, MAF 2008 Asset Allocation, Longevity Risk, Annuitisation and Bequests - p. 23/24
 References (4)

Outline
[15] G. Stabile, Optimal Timing of the Annuity Purchase: A
Motivation
Combined Stochastic Control and Optimal Stopping
Assumptions
Problem, International Journal of Theoretical and Applied
Optimisation Problem Finance 9(2) (2006)
Results
[16] M. Yaari, Uncertain Lifetime, Life Insurance, and the
Conclusions
Theory of the Consumer, Review of Economic Studies 2
Thanks
(1965) 137-150
Back-up
● Indirect Utility (2)
● Continuation Region
● Investment in the Bequest
Case γ > 1
● Consumption in the Bequest
Case γ > 1
● References (1)
● References (2)
● References (3)
● References (4)

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