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Abstract
This thesis explores the economic issues associated with the payout phase where a defined contribution (DC) retirement arrangement is adopted. In particular, the role of annuities in providing a retirement income is examined as well as insurance they provide against retirement risks such as inflation, longevity and rate of return volatility.
A comprehensive money’s worth calculation based on a Australian population cohort mortality table shows that overall, Australian nominal and inflation indexed life annuities provide relatively good value for money. Although relative to annuities sold in the US and the UK they do suffer from relatively high adverse selection costs, which could in turn reduce demand. In addition, the presence of a government provided safety net pension could also result in low demand for annuities.
These two issues suggest that government intervention may be warranted to ensure retirees have access to affordable private insurance to protect their retirement benefit. This could take the form of mandating an annuity purchase at retirement. However, which annuity should be mandated is not well understood. This is an important question as there are many alternative annuity designs, each providing different degrees of retirement risk protection to an individual.
This thesis uses numerical simulations to empirically analyse the costs and benefits of mandating alternative annuities from both an individual and government’s perspectives to determine optimal annuity design.
A model is used to estimate the value of payouts over time from various types of annuities across a range of retirement benefits. A means tested safety net pension is assumed to exist. Two stochastic variables — inflation and the risky rate of return, are simultaneously used to show how the annuity payouts react to theses changes, highlighting the insurance features of various annuities.
Consumer preferences for the various annuities are estimated based on tolerance to risk. The variable annuity dominates the utility rankings under two conditions: -- when the relative risk aversion is low and a safety net payment isn’t available, and when the relative risk aversion is high and a safety net payment is made. Otherwise the CPI indexed annuity has the highest ranking. Sensitivity analysis shows that the results presented here are robust to a number of alternative assumptions about the key variables.