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.