Abstract:

It is well known that most rational life-cycle models predict much larger annuitization levels than those

observed empirically. We examine the relative importance of three leading explanations for low annuity

demand: health cost risk, incomplete annuity menus, and bequest motives. We find that high health cost risk

can potentially explain very low annuity demand, while incomplete annuity menus and realistic bequest motives

cannot. We find that the timing of the health cost risk is important. If out-of-pocket medical expenses

can already be sizeable early in retirement, empirically observed low annuitization levels are optimal. In

case health cost risk early in retirement is low, individuals can better save out of their annuity income to

build a buffer for health cost shocks at later ages. Empirical evidence shows that in the US for many individuals

health cost risk is indeed substantial early in retirement. Incomplete annuity markets do not reduce

predicted annuity levels to the empirical levels, as agents are better of buying nominal annuities, save out of

this income, and invest that in equity. Very high bequest motives can explain the low empirically observed

annuity levels, but generate savings behavior inconsistent with the data.