WEI-YIN HU, Financial Engines, Inc.
Email: whu@financialengines.com
JASON S. SCOTT, Financial Engines, Inc.
Email: jscott@financialengines.com

As Baby Boomers enter retirement, they will look to the investment industry for ways to generate income from accumulated savings. Why most retirees do not purchase longevity insurance in the form of lifetime annuities is a long-standing puzzle. Mental accounting and loss aversion can explain the unpopularity of annuities by framing them as risky gambles where potential losses loom larger than potential gains. Moreover, behavioral anomalies can explain the prevalence of period certain annuities, which guarantee a minimum number of payouts. Finally, investors may prefer longevity annuities purchased today to begin payouts in the future to immediate annuities because investors overweight the small probability of living long enough to receive large future payouts.

ZVI BODIE, Boston University - Department of Finance & Economics
Email: zbodie@bu.edu
DORIANA RUFFINO, Boston University - Department of Economics
Email: rdoriana@bu.edu
JONATHAN TREUSSARD, Boston University - Department of Economics
Email: jtreussa@bu.edu

This paper explores the application of contingent claims analysis (CCA) to two "hot" issues in life-cycle finance: (1) investing for retirement and (2) deciding when, if ever, to switch careers. Participants in individual retirement accounts do not have the time or the knowledge to make their own investment decisions. Today they are defaulted into life-cycle mutual funds that pass all risk directly through to the participant. We use CCA to demonstrate how financial firms can design and produce guaranteed contingent benefit contracts that improve participant welfare at no additional cost to the system. In exploring the career-choice issue in the second part of the paper, we use CCA in a somewhat different way. The decision to switch careers is analogous to deciding when to exercise an American-style option to swap one asset for another. By applying the methods used to analyze the option-exercise decision to the career-switching problem, we gain some new insights beyond those derived from the traditional dynamic programming approaches.

MARTIN F. GRACE, Georgia State University - Risk Management & Insurance Department, Georgia State University - Andrew Young School of Policy Studies
Email: mgrace@gsu.edu
ROBERT W. KLEIN, Georgia State University - Center for Risk Management and Insurance Research
Email: rwklein@gsu.edu

In this report we examine the likely effects of an Optional Federal Charter (OFC) regulatory system on competition in the life insurance and annuities industry and related markets. Increasingly, many US insurers advocate the creation of an OFC and the associated regulatory framework for several reasons. Primarily, they believe that the adoption of an OFC would reduce the costs and impediments imposed by the current state-based regulatory system. Further, they believe that the adoption of an OFC structure will facilitate interstate operations and enhance the industry's competitiveness relative to other financial service providers and international insurers. The proposal of an OFC system has generated an intensive debate on a number of issues, including its implications for market competition and the associated effects on consumers. Based on our analysis, we conclude that the life insurance industry is structurally competitive based on its inherent characteristics but that many insurers have not fully achieved maximum efficiency due, at least in part, to the barriers and costs caused by state regulation. Our analysis further leads us to the opinion that the creation of an OFC, properly structured and implemented, would likely increase competition in the US life insurance industry, the broader market for financial services, and international insurance markets.

A. (TASSOS) G. MALLIARIS, Loyola University of Chicago
Email: tmallia@luc.edu

Numerous studies have estimated U.S. stock market returns measured by various indexes such as the S&P 500 Index over certain periods. The purpose of this paper is twofold: first we calculate, under certain scenarios, the final total accumulation of a representative individual who invests a certain amount of funds per month during a long investment horizon of say 30 or 40 years. Second, we evaluate the performance of such an investment plan of defined monthly contributions. This evaluation is based on a benefit target and working backwards we compute the necessary monthly contributions. In our calculations we use actual monthly returns of the S&P 500 Index instead of averages obtained from a large sample. We calculate that accumulations of gradual investments over 30 or 40 years are skewed to the right and we also compute the probability that a given percentage of contributions will be sufficient to finance certain retirement benefits.

WOLFRAM J. HORNEFF, Goethe University Frankfurt - Department of Finance
Email: horneff@finance.uni-frankfurt.de
RAIMOND MAURER, University of Frankfurt - Faculty of Business and Economics
Email: Rmaurer@wiwi.uni-frankfurt.de
MICHAEL Z. STAMOS, Goethe University Frankfurt, Allianz Global Investors
Email: stamos@wiwi.uni-frankfurt.de

We compute the optimal dynamic annuitization and asset allocation policy for a retiree with Epstein/Zin preferences, uncertain investment horizon, potential bequest motives, and pre-existing pension income. In our setting the retiree can decide each year how much he consumes and how much he invests in stocks, bonds, and life annuities, while the prior literature mostly considered restricted so-called deterministic or stochastic switching strategies. We show that postponing the annuity purchase is no longer optimal in the gradual annuitization case since investors are able to attain the optimal mix between liquid assets (stocks and bonds) and illiquid life-annuities each year. In order to assess potential utility losses, we benchmark various restricted annuitization strategies against the unrestricted gradual annuitization strategy.

GAOBO PANG, Watson Wyatt Worldwide
Email: Gaobo.Pang@watsonwyatt.com
MARK J. WARSHAWSKY, Watson Wyatt Worldwide
Email: MARK.WARSHAWSKY@DO.TREAS.GOV

This paper derives optimal equity-bond-annuity asset portfolios for households in the retirement phase who, with or without a bequest motive, face stochastic capital market returns, have differential exposures to mortality risk and uncertain uninsured health expenses, and have differential Social Security and defined benefit pension coverage. The numerical results show that the presence of health spending risk drives households to shift their portfolios from risky equities to safer assets and works to enhance the demand for annuities due to their increasing-with-age superiority over bonds as a hedge against life-contingent health spending as well as longevity risks. The safe and higher-return annuities in turn provide a greater leverage for equity investment in the remaining asset portfolios. This health-spending-uncertainty-enhanced optimal annuitization result is compatible with the broader theory about liquidity constraints and precautionary savings.

A. (TASSOS) G. MALLIARIS, Loyola University of Chicago
Email: tmallia@luc.edu
MARY MALLIARIS, Loyola University of Chicago
Email: mmallia@luc.edu

The phenomenal growth of individual retirement accounts in the U.S., and globally, challenges both individuals and their advisors to rationally manage these investments. The two essential differences between an individual retirement account and an institutional portfolio are the length of the investment horizon and the regularity of monthly contributions. The purpose of this paper is to contrast principles of institutional investing with the management of individual retirement accounts. Using monthly historical data from 1926 to 2005 we evaluate the suitability for managing individual retirement portfolios of seven principles employed in institutional investing. We discover that some of these guidelines can be beneficially applied to the investment management of individual retirement accounts while others need to be reconsidered.

KATHRYN J. KENNEDY, John Marshall Law School
Email: 7kennedy@jmls.edu

Federal legislation passed in 2006 affords participants and beneficiaries of eligible retirement benefits new distribution options that can result in the reduction or deferral of federal income taxes. These new distribution options may have the domino effect of making rollovers to IRAs a more desirable funding vehicle. If this occurs, the continued interest in self-directed IRAs (i.e., where the IRA owner is not limited to the IRA trustee's or custodian's investment options, but instead can choose his investment options) will become increasingly marketed by custodians. Self-directed IRA owners appear to be particularly interested in real estate investments. In a two-part article, the first part explores the new benefit distribution options, whereas the second part discusses the practical and legal issues that IRA owners should consider before making self-directed investment decisions, especially with respect to real estate investments.