# Asset Allocation and Annuity-Purchase Strategies. to Minimize the Probability of Financial Ruin. Moshe A. Milevsky 1. Kristen S.

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1 Asset Allocation and Annuity-Purchase Strategies to Minimize the Probability of Financial Ruin Moshe A. Milevsky 1 Kristen S. Moore 2 Virginia R. Young 3 Version: 18 October 25 1 Schulich School Of Business, York University, Toronto, Ontario, Canada 2 Department of Mathematics, University of Michigan, Ann Arbor, Michigan, USA Fax: phone: Department of Mathematics, University of Michigan, Ann Arbor, Michigan, USA 1

2 Asset Allocation and Annuity-Purchase Strategies to Minimize the Probability of Financial Ruin Abstract: In this paper, we derive the optimal investment and annuitization strategies for a retiree whose objective is to minimize the probability of lifetime ruin, namely the probability that a fixed consumption strategy will lead to zero wealth while the individual is still alive. Recent papers in the insurance economics literature have examined utility-maximizing annuitization strategies. Others in the probability, finance, and risk management literature have derived shortfall-minimizing investment and hedging strategies given a limited amount of initial capital. This paper brings the two strands of research together. Our model pre-supposes a retiree who does not currently have sufficient wealth to purchase a life annuity that will yield her exogenously desired fixed consumption level. She seeks the asset allocation and annuitization strategy that will minimize the probability of lifetime ruin. We demonstrate that because of the binary nature of the investor s goal, she will not annuitize any of her wealth until she can fully cover her desired consumption with a life annuity. We derive a variational inequality that governs the ruin probability and the optimal strategies, and we demonstrate that the problem can be recast as a related optimal stopping problem which yields a free-boundary problem that is more tractable. We numerically calculate the ruin probability and optimal strategies and examine how they change as we vary the mortality assumption and parameters of the financial model. Moreover, for the special case of exponential future lifetime, we solve the (dual) problem explicitly. As a byproduct of our calculations, we are able to quantify the reduction in lifetime ruin probability that comes from being able to manage the investment portfolio dynamically and purchase annuities. JEL Classification: J26; G11 Keywords: Insurance, life annuities, retirement, optimal investment, shortfall risk, stochastic optimal control, barrier policies, dynamic programming, free-boundary problem, variational inequality 2

3 1. Introduction and Motivation More individuals are responsible now than in recent decades for managing their retirement portfolios through defined contribution plans, such as 41(k)s and 43(b)s, in lieu of defined benefit pension plans. Indeed, in 1998, 62.7% of individuals who participated in a retirement plan had a defined contribution plan as their primary plan, much higher than the 49.8% found in 1993 (Copeland, 22). In a recent issue of The Actuary (Parikh, 23), Jeff Mohrenweiser states that an [American Council of Life Insurers] report found that seventy-one percent of the women and sixty percent of the men surveyed are concerned that it will be difficult to make their retirement savings last a lifetime. This concern is justified; VanDerhei and Copeland (23) report that American retirees will have at least \$45 billion less in retirement income in 23 than what they will need to cover their expenses. This shortfall highlights the need for individuals to receive good advice about managing their wealth. Global pension reform and the trend towards privatization has focused much academic and practitioner attention on the market for voluntary life annuities, as an alternative to defined benefit pensions. A fixed-payout life annuity is a financial instrument that pays a fixed amount periodically (for example, monthly or annually) throughout the life of the recipient; the payments are contingent on the recipient s survival. Since they provide guaranteed, periodic income, life annuities are instrumental in helping individuals sustain a given level of consumption. Recent proposed legislation giving tax incentives for individuals who purchase these instruments testifies to their potential effectiveness in preventing poverty in retirement (Cummins, 24). While life annuities themselves are hundreds of years old see Poterba (1997) for a brief history it is only recently that they have attracted the attention of noted financial and insurance economists, such as Feldstein and Ranguelova (21), as an alternative to Social Security. Though life annuities do provide income security in retirement, very few retirees choose a life annuity over a lump sum. According to a recent survey, 86% of retirees said that guaranteed lifetime income is very important, and 87% of retirees said that they would like to receive their pension as a series of regular payments for life (Society of Actuaries, 24); however, very few people actually elect a life annuity. Indeed, in a recent comprehensive Health and Retirement Survey, only 1.57% of the respondents reported annuity income; similarly, only 8.% of respondents with a defined contribution pension plan selected an annuity payout. In a well-cited paper from the public economics literature, Yaari (1965) proved that in the absence of bequest motives and in a deterministic financial economy consumers will 3

5 under such a strategy. We, then, present our formal optimization model and use optimal stochastic control to derive a variational inequality that governs the ruin probability and optimal strategies. We show that the annuitization strategy is a barrier strategy defined by the barrier at which the marginal ruin probability with respect to annuity income and the (adjusted) marginal ruin probability with respect to wealth are equal. This type of result namely, taking no action until the marginal benefit is at least equal to the marginal cost is seen often in the economics literature. The annuity-purchasing problem is qualitatively similar to the problem of optimal consumption and investment in the presence of proportional transaction costs. The difference between the two problems is that for us, once the individual s wealth reaches the barrier, then she annuitizes all her wealth, and the game is over, as we show in Section 3. Friedman and Shen (22) applied similar stochastic control methods to problems in retirement planning and insurance. In Section 3, we reduce the dimension of the variational inequality obtained in Section 2. In Section 2, the probability of lifetime ruin is given as a function of the current time, the wealth w at that time, and the annuity income A at that time. If c denotes the (fixed) desired consumption rate, then it turns out the probability of lifetime ruin is a function of z = w/(c A) and time, so we can reduce the dimension of the problem by one. We, then, study properties of the optimal investment and annuity-purchasing policies. We show that if wealth exceeds the actuarial present value of the investor s lifetime shortfall in consumption, then she will purchase a lump sum annuity to guarantee her desired consumption rate so that she will never ruin. Conversely, if wealth is less than the actuarial present value of the shortfall in consumption, then the individual will buy no annuity at that time but wait until wealth is great enough, a rather surprising bang-bang result that is inherited from the nature of the investor s goal and stands in contrast to the instantaneous control policy that would apply if the objective were to maximize expected utility of lifetime consumption and bequest (Milevsky and Young, 23). In Section 4, we use duality techniques to transform the nonlinear partial differential equation for the probability of lifetime ruin (with known boundary conditions) to a linear free-boundary problem. In Section 5, we solve the free-boundary problem for a special case and contrast our results with those in Section 2.1, where no annuities or risky assets were available to the individual. In this way, we quantify the benefits of dynamic portfolio management, in which the portfolio includes life annuities and a risky asset. In Section 6, we use the connection between free-boundary problems and variational inequalities for optimal stopping problems in order to compute ruin probabilities and optimal strategies for more general cases than the one considered in Section 5. Section 7 concludes the paper. 5

6 2. Probability of Lifetime Ruin In this section, we formulate our models for the probability of lifetime ruin first in the case of deterministic returns, then in the case of stochastic returns Self-Annuitization with Deterministic Returns In this section, we consider a simple model in which an individual can invest only in a riskless asset earning rate r. We assume that she begins with wealth 1 and selfannuitizes; that is, she consumes a level amount c per year until she dies or runs out of money, whichever comes first. We compute the time of ruin, and under the assumption of exponential future lifetime, we compute the probability of lifetime ruin. In Section 5.2, we contrast these results with those for an investor who can trade dynamically between riskless and risky assets and who can purchase annuities instead of self-annuitizing. We start with a future lifetime random variable τ d that is exponentially distributed, for which the probability of survival is given by Pr[τ d > t] = e λt, (2.1) in which λ is the instantaneous hazard rate (or force of mortality). The greater the hazard rate λ, the lower the probability of survival to any given age t. In this paper, we refer to prices of life annuities. Formally, the price (or present value) of a payout annuity (for life, with no guarantee period) that pays \$1 per year continuously is computed via e rt Pr[τ d > t]dt. (2.2) It is effectively equal to the present value of \$1 per year discounted by the riskless rate and the probability of survival. The greater the interest rate, the lower the present value of the life annuity. For exponential mortality with hazard rate λ, the annuity price equals e rt e λt dt = 1 r + λ. (2.3) Note that the hazard rate acts as a discount factor in equation (2.3). Actuaries often say when computing such an expression that they are discounting for interest and mortality. Thus, for example, if the hazard rate is λ =.5 (which means that future life expectancy is 2 years) and the interest rate in the (annuity) market is r =.7, the price of \$1 per year for life is 1/.12 = 8.33 dollars. Stated differently, one dollar of initial premium will yield a fixed annuity payout of λ+r =.12 dollars per year for life. However, when the 6

7 (initial) future life expectancy is only 1 years, which implies the hazard rate is λ =.1, then under an r =.7 interest rate, the cost of \$1 for life is only 1/.17 = 5.88 dollars. Equivalently, the payout per initial dollar of premium is.17 dollars per year. In the deterministic case, we use the function W(t) to denote the wealth at time t of the retiree assuming she does not annuitize. Instead, she consumes a constant amount c per year until she either runs out of money or she dies (whichever comes first). We quantify the dynamics of the wealth process and compute the probability she will run out of money while she is still alive. To simplify our work, we assume that there is only one interest rate r in the economy (that is, no term structure or expenses) and that all annuities are priced (fairly) as a function only of the hazard rate and interest rate (that is, we ignore loading and expenses because these can be absorbed in the pricing hazard rate; see the discussion following (2.9)). Formally, under a self-annuitization strategy, the wealth process of the retiree obeys the ordinary differential equation: dw(t) = (rw(t) c)dt, W() = 1. (2.4) The individual retires with \$1 of wealth, invests at a rate of r, and consumes at a rate of c. Intuitively, therefore, wealth increases at the interest rate at which money is invested minus the consumption rate. The solution to this ordinary differential equation is ( e W(t) = e rt rt ) 1 c, t t, (2.5) r and after time t, in which t is the point at which the process hits zero (that is, the individual is ruined). One can interpret this expression for W(t) as the value at time t of the initial \$1 minus the accumulated value of the continuous withdrawal due to consumption at rate c. Now, assume the consumption rate is set equal to c = λ + r, which is the amount of life annuity income that \$1 will provide. In this self-annuitization case, the ruin time t, the point at which the function W(t) reaches zero, equals t = 1 ( r ln 1 + r ). (2.6) λ By substituting (2.6) into (2.1), we learn that the probability of surviving to the point at which the funds are exactly exhausted is Pr[τ d > t ] = exp( λt ) = 7 ( 1 + r ) λ r. (2.7) λ

8 In Section 5.2, we contrast the probability of lifetime ruin in the deterministic case (2.7) with the probability of lifetime ruin when we allow random returns Stochastic Returns In this subsection, we formalize the optimal annuity-purchasing and optimal investment problem for an individual who seeks to minimize the probability that she outlives her wealth. A priori, we allow the individual to buy annuities in lump sums or continuously, whichever is optimal. Our results are similar to those of Dixit and Pindyck (1994, pp 359ff), which are given in the context of real options. They consider the problem of a firm s (irreversible) capacity expansion. In our model, annuity purchases are also irreversible, and this leads to the similarity in results. We assume that the individual can invest in a riskless asset whose price at time s, X s, follows the process dx s = rx s ds, X t = x >, for some fixed r, as in the previous subsection. However, unlike the previous subsection, the individual can also invest in a risky asset whose price at time s, S s, follows geometric Brownian motion given by { dss = µs s ds + σs s db s, S t = S >, (2.8) in which µ > r, σ >, and B s is a standard Brownian motion with respect to a filtration {F s } of the probability space (Ω, F,Pr). Let W s be the wealth at time s of the individual (after possibly purchasing annuities at that time), and let π s be the amount that the decision maker invests in the risky asset at time s. It follows that the amount invested in the riskless asset is W s π s. Also, the decision maker consumes at a constant rate of c. Our economy can be either real or nominal. When our model is interpreted in nominal terms, then the fixed consumption rate c is nominal, and we assume that the individual buys annuities that pay a fixed nominal amount. In practice, of course, this exposes the retiree to inflation risk since c today will buy much more than c in twenty years. However, if c is real, then we assume that the individual (only) has access to annuities that are indexed to inflation and thereby pay a fixed real amount. Also, in this case, the returns on the riskless and risky assets are stated in real returns. We prefer to think of the model in real terms, and our numerical examples are presented in real terms so that inflation risk, which would be a problem if c were stated in nominal terms, is not an issue. We employ a modified version of standard actuarial notation as in Bowers et al. (1997). We write λ S (t) to denote the individual-specific hazard rate at age t. Similarly, λ O denotes the objective hazard rate function used to price annuities. The actuarial present value of a life annuity that pays \$1 per year continuously to an individual aged t based on the hazard 8

9 rate function λ O is written ā(t). The (objective) ( probability that our individual aged t survives an additional s years equals exp ) t+s λ O (u)du. It is the analog of e λs in t the case for which τ d is exponentially distributed, as in (2.1). As in (2.2), to compute the actuarial present value of the life annuity, we discount the payment stream of \$1 per year by the interest rate r and the hazard rate λ O. ā(t) = ( t+s ) e rs exp λ O (u)du ds. (2.9) t Throughout this paper, time coincides with the age of the individual; that is, at time t, the individual is age t. Note that the discount for mortality in (2.9) makes ā(t) < 1/r, the price of a perpetuity that pays \$1 per year continuously. To clarify, by ā(t), we mean the actual market price of the life annuity for an individual aged t. We deliberately refrain from discussing anti-selection, which creates the wedge between individual-specific and pricing (or objective) hazard rates. In addition, we omit actuarial loading fees, agent commissions, and other market imperfections that only add to the cost of annuities and can be absorbed in the pricing hazard rate. The individual has a non-negative income rate at time (or age) s of A s after any annuity purchases at that time (A s before any annuity purchases at time s). Initial income could include Social Security benefits and defined benefit pension benefits, for example, but we assume that additional income only arises from buying life annuities by using money from current wealth. We assume that she can purchase a life annuity at the price of ā(s) per dollar of annuity income at time s. Thus, wealth follows the process dw s = [rw s + (µ r)π s + A s c]ds + σπ s db s ā(s)da s, W t = w, A t = A. (2.1) The negative sign for the subscript on the random processes denotes the left-hand limit of those quantities before any (lump sum) annuity purchases. In order to reduce the number of variables in this problem, we define X s = c A s. X s denotes the excess consumption that the individual requires; in other words, X s is the net consumption. By formulating the problem in terms of X s, we will be able to reduce the dimension of the problem more easily in Section 4. With this new random variable, (2.1) becomes 9

10 dw s = [rw s + (µ r)π s X s ]ds + σπ s db s + ā(s)dx s, W t = w, X t = x. (2.11) We assume that the decision maker seeks to minimize, over admissible strategies {π s, X s }, her probability of lifetime ruin, namely, the probability that her wealth drops to zero before she dies. Admissible strategies {π s, X s } are those that are measurable with respect to the information available at time s, namely F s, that restrict the excess consumption process X to be non-negative and non-increasing (that is, life annuity purchases are irreversible), and that result in (2.11) having a unique solution; see Karatzas and Shreve (1998), for example. Note that π s is unconstrained; thus, the investment in the risky asset can exceed current wealth (and often does, as we will see in Section 6.3). The individual values her probability of lifetime ruin via her specific hazard rate, while annuities are priced by using the objective hazard rate. Denote the random time of death of our individual by τ d, as in the previous subsection, and the random time of lifetime ruin by τ ; that is, τ is the time at which wealth reaches zero. Thus, the probability of lifetime ruin ψ for the individual at time t defined on D = {(w, x, t) : w xā(t), x, t } is given by ψ(w, x, t) = inf Pr [τ < τ d W t = w, X t = x, τ d > t, τ > t]. (2.12) {π s,x s } Note that if w xā(t), then the individual can purchase an annuity that will guarantee her an income of x = c A, which added to her income of A, gives her income to match her consumption rate of c. Thus, ψ(w, x, t) = for w xā(t). If life annuities were not available, securing lifetime income would necessitate acquiring a perpetuity, which would cost 1/r per \$1 of income, much more than the life annuity. This was the problem analyzed by Young (24). We continue with a formal derivation of the associated Hamilton-Jacobi-Bellman (HJB) variational inequality. First, note that the problem is one that combines continuous control (via the investment strategy π s ) and singular control (via the excess consumption strategy X s = c A s ). Indeed, suppose that we could write dx s = χ s ds for some rate χ s ; that is, suppose that it is optimal to buy annuities at a continuous rate. Then, the HJB equation would contain a term of the form χā(t)ψ x (w, x, t), which arises from (2.11), and that term would be minimized by setting χ = or χ = depending on the sign of ψ x. Therefore, no such rate χ s exists, and the problem of choosing the optimal excess 1

11 consumption strategy is one of singular control; see Harrison and Taksar (1983) for an early relevant reference in mathematical finance. Now, suppose that at the point (w, x, t), it is optimal not to purchase any annuities. It follows from Itô s lemma that ψ satisfies the equation λ S (t)ψ = ψ t + (rw x)ψ w + min [(µ r)πψ w + 12 ] σ2 π 2 ψ ww. (2.13) π Because the above policy is in general suboptimal, (2.13) holds as an inequality; that is, for all (w, x, t), λ S (t)ψ ψ t + (rw x)ψ w + min [(µ r)πψ w + 12 ] σ2 π 2 ψ ww. (2.14) π Next, assume that at the point (w, x, t), it is optimal to buy an annuity instantaneously. In other words, assume that the investor moves instantly from (w, x, t) to (w ā(t) x, x x, t), for some x >. Then, the optimality of this decision implies that which in turns yields ψ(w, x, t) = ψ(w ā(t) x, x x, t), (2.15) ā(t)ψ w (w, x, t) + ψ x (w, x, t) =. (2.16) Note that the lump-sum purchase is such that (the negative of) the derivative of the probability of lifetime ruin with respect to excess consumption equals the adjusted derivative with respect to wealth, in which we adjust by the cost of \$1 of annuity income ā(t). This is parallel to many results in economics. Indeed, the derivative of the probability of lifetime ruin with respect to excess consumption can be thought of as the marginal utility of the benefit, while the adjusted derivative with respect to wealth can be thought of as (the negative of) the marginal utility of the cost. We say negative here because ψ is decreasing with respect to w. Thus, the lump-sum purchase forces the marginal utilities of benefit and cost to equal. However, such a lump-sum purchasing policy is in general suboptimal; therefore, (2.16) holds as an inequality and becomes ā(t)ψ w (w, x, t) + ψ x (w, x, t). (2.17) 11

12 By combining (2.14) and (2.17), we obtain the HJB variational inequality (2.18) below associated with the probability of ruin ψ given in (2.12). The following result can be proved as in Zariphopoulou (1992), for example. Proposition 2.1: The probability of lifetime ruin is a constrained viscosity solution of the Hamilton-Jacobi-Bellman variational inequality [ max λ S (t)ψ ψ t (rw x)ψ w min [(µ r)πψ w + 12 ] ] σ2 π 2 ψ ww, ā(t)ψ w + ψ x π =. (2.18) In the next section, we show that the barrier in (2.16) is the line w = xā(t); thus, the individual will annuitize when she has sufficient wealth to cover her shortfall of x = c A. If wealth and annuity income initially lie to the right of the barrier at time t, that is, w xā(t), then the individual will immediately spend a lump sum of wealth to guarantee that the probability of lifetime ruin is zero. Otherwise, the annuity income is constant when wealth is low enough, that is, w < xā(t). Once wealth is high enough, that is, w = xā(t), the individual will spend her wealth to guarantee an income rate of x + A = c to match her consumption rate of c. Thus, as in Dixit and Pindyck (1994, pp 359ff) or in Zariphopoulou (1992), we have discovered that the optimal annuity-purchasing scheme is a type of barrier control. Other barrier control policies appear in finance and insurance. In finance, Zariphopoulou (1999, 21) reviews the role of barrier policies in optimal investment in the presence of transaction costs; also see the references within her two articles. See Gerber (1979) for a classic text on risk theory in which he includes a section on optimal dividend payout and shows that it follows a type of barrier control. See Neuberger (22) for an analysis that is similar to ours in the setting of maximizing expected utility of consumption. 3. Reducing the Dimension of the Minimization Problem In this section, we show that we can reduce the dimension of the variational inequality (2.18) by transforming the ruin probability ψ(w, x, t) to a function of two variables. We also show that the barrier described by (2.16) corresponds with the line w = xā(t). The probability of lifetime ruin ψ is a function of the ratio z = w/x and time t. Indeed, ψ(w, x, t) = ψ(z, 1, t) by scaling the entire problem by x = c A. This observation is also made in Milevsky and Robinson (2), where the probability of lifetime ruin is shown to depend only on the ratio of current wealth to desired consumption. Davis and 12

14 for z < ā(t), with boundary conditions V (, t) = 1 and V (ā(t), t) = and with transversality condition lim s exp ( s t λs (u)du ) E[V (Zs, s) Z t = z] =, in which Zs is the optimally controlled Z s. For a given set of controls, note that Z s equals the process W s when x = 1. One can prove Proposition 3.1 formally by using an approach similar to the one in Harrison and Taksar (1983). In fact, the transversality condition arises from the (here-unstated) verification lemma underlying this proposition. In the next section, we show that (3.3) has a smooth solution in the classical sense. 4. Linearizing the Equation for V via Duality Arguments In this section, we transform the nonlinear boundary-value problem in (3.3) to a linear free-boundary problem via the Legendre transform; see Karatzas and Shreve (1998). To this end, we first eliminate the λ S (t)v term from (3.3) by defining It follows that (3.3) becomes ( t ) f(z, t) = exp λ S (u)du V (z, t). f t + (rz 1)f z + min [(µ r)ˆπf z + 12 ] σ2ˆπ 2 f zz =, (4.1) ˆπ ( with boundary conditions f(, t) = exp ) t λs (u)du and f(ā(t), t) = and with transversality condition lim s E[f(Zs, s) Z t = z] =. This condition can be rewritten as lim t f(z, t) = with probability 1 because f 1. Next, consider the concave dual of f defined via the Legendre transform by f(y, t) = min[f(z, t) + zy]. (4.2) z> The critical value z solves the equation f z (z, t) + y = ; thus, z = I( y, t), in which I is the inverse of f z with respect to z. It follows that Note that f(y, t) = f[i( y, t), t] + yi( y, t). (4.3) f y (y, t) = f z [I( y, t)]i y ( y, t) + I( y, t) yi y ( y, t) = yi y ( y, t) + I( y, t) yi y ( y, t) = I( y, t). (4.4) 14

15 We can retrieve the function f from f by the relationship f(z, t) = max y> [ f(y, t) zy]. (4.5) Indeed, the critical value y solves the equation f y (y, t) z = ; thus, y = f z (z, t), and f(y, t) zy = f[i( y, t), t] + y I( y, t) zy = f[i(f z (z, t), t), t] f z (z, t)i(f z (z, t), t) + zf z (z, t) = f(z, t) zf z (z, t) + zf z (z, t) = f(z, t), in which we use equation (4.3) for the first equality. Next, note that f yy (y, t) = I y ( y, t) = 1/f zz [I( y, t), t], (4.6) and f t (y, t) = f z [I( y, t), t]i t ( y, t) + f t [I( y, t), t] + yi t ( y, t) = yi t ( y, t) + f t [I( y, t), t] + yi t ( y, t) = f t [I( y, t), t]. In the partial differential equation for f, let z = I( y, t) to obtain (4.7) f t [I( y, t), t] + (ri( y, t) 1)f z [I( y, t), t] 1 ( ) 2 µ r (f z [I( y, t), t]) 2 2 σ f zz [I( y, t), t] =. Rewrite this equation in terms of f to get in which m = 1 2 f t (y, t) + (ri( y, t) 1)( y) m ( y)2 1/ f yy (y, t) =, ( µ r ) 2, σ or equivalently, f t (y, t) ry f y (y, t) + my 2 fyy (y, t) + y =, (4.8) ( with boundary conditions given implicitly by f(, t) = exp ) t λs (u)du and f(ā(t), t) =. ( Now, consider the boundary conditions f(, t) = exp ) t λs (u)du and f(ā(t), t) =. Because f z < is strictly increasing with respect to z, we have y (t) > y b (t) for all t, in which y (t) and y b (t) are defined by y (t) = f z (, t), (4.9) 15

16 and y b (t) = f z (ā(t), t). (4.1) We use subscript to denote the point corresponding to wealth equal to, and we use subscript b to denote the point corresponding to the value of wealth at which the individual buys a life annuity. and Thus, the boundary conditions become ( t ) f(y (t), t) = exp λ S (u)du, for f y (y (t), t) =, (4.11) f(y b (t), t) = ā(t)y b (t), for f y (y b (t), t) = ā(t). (4.12) The transversality condition lim t f(z, t) = becomes lim t f(y, t) =. Note that the first equations in (4.11) and (4.12) are reminiscent of value matching conditions, while the second equations are reminiscent of smooth pasting conditions. We exploit this observation in Section 6, where we express f as the value function for an optimal stopping problem. Thus, we are able to solve the free-boundary problem numerically. Before pursuing this numerical method, we obtain an exact solution for ψ in a special case in Section Solution of the Free-Boundary Problem for a Special Case: Constant Hazard Rate Throughout this section, we assume that the forces of mortality are constant; that is, that λ S (t) λ S and λ O (t) λ O for all t. In this case, the ruin probability ψ is independent of time, and the partial differential equation in (3.3) is an ordinary differential equation. We use this time-homogeneity to compute a implicit analytical solution of ψ Solution of the Boundary-Value Problem If we assume that the forces of mortality are constant, (3.3) becomes the ordinary differential equation: λ S V = (rz 1)V + min ˆπ with boundary conditions V () = 1 and V (1/(r + λ O )) =. ((µ r)ˆπv + 12 σ2ˆπ 2 V ), (5.1) If we define the concave dual of V by Ṽ (n) = min z>[v (z)+zn], as in Section 4, then we obtain the following free-boundary problem for Ṽ : λ S Ṽ (n) (r λ S )nṽ (n) + mn 2 Ṽ (n) + n =, (5.2) 16

17 with boundary conditions Ṽ (n ) = 1, for Ṽ (n ) =, (5.3) and Ṽ (n b ) = The general solution of (5.2) is n b r + λ O, for Ṽ (n b ) = 1 r + λ O. (5.4) Ṽ (n) = D 1 n B 1 + D 2 n B 2 + n r, (5.5) with D 1 and D 2 constants determined by the boundary conditions, and with B 1 and B 2 given by and and B 1 = 1 [ ] (r λ S + m) + (r λ 2m S + m) 2 + 4mλ S > 1, (5.6) B 2 = 1 [ ] (r λ S + m) (r λ 2m S + m) 2 + 4mλ S <. (5.7) The boundary conditions at n b give us D 1 n B 1 b + D 2 n B 2 b + n b r = D 1 B 1 n B 1 b + D 2 B 2 n B 2 b + n b r = Solve equations (5.8) and (5.9) to get D 1 and D 2 in terms of n b : and λ O n b r + λ O, (5.8) n b r + λ O. (5.9) 1 B 2 D 1 = n 1 B 1 r(r + λ O b <, (5.1) ) B 1 B 2 B 1 1 D 2 = r(r + λ O n 1 B 2 b <. (5.11) ) B 1 B 2 λ O Next, substitute for D 1 and D 2 in the second equation in (5.3), namely D 1 B 1 n B 1 1 D 2 B 2 n B r =, to get λ O r + λ O B 1 (1 B 2 ) B 1 B 2 ( n n b ) B1 1 + λo r + λ O B 2 (B 1 1) B 1 B 2 ( ) B2 1 n n b + = 1. (5.12) Equation (5.12) gives us an equation for the ratio n /n b > 1. To check that (5.12) has a unique solution greater than 1, note that the left-hand side (1) equals λ O /(r + λ O ) < 1 when we set n /n b = 1, (2) goes to infinity as n /n b goes to infinity, and (3) is strictly increasing with respect to n /n b. 17

18 Next, substitute for D 1 and D 2 in the first equation in (5.3), namely D 1 n B D 2 n B r = 1 n to get 1 B 2 r(r + λ O ) B 1 B 2 λ O ( ) B1 1 n n b λ O B 1 1 r(r + λ O ) B 1 B 2 ( ) B2 1 n n b + 1 r = 1 n. (5.13) Substitute for n /n b in equation (5.13), and solve for n. Finally, we can get n b from n b = n n /n b, (5.14) and D 1 and D 2 from equations (5.1) and (5.11), respectively. Once we have the solution for Ṽ, we can recover V by ] V (z) = max [Ṽ (n) zn n> = max n> [D 1 n B 1 + D 2 n B 2 + n r zn ], (5.15) in which the critical value n solves D 1 B 1 n B D 2 B 2 n B r = z. (5.16) Thus, for a given value of z = w/x, solve (5.16) for n and plug that value of n into (5.15) to get ψ(w, x) = V (z). Also of interest is the amount invested in the risky asset, especially as wealth approaches the annuitization level x/(r + λ O ). π (w, x) = xˆπ (z) = x µ r σ V (z) V (z) = xµ r σ nṽ (n). Now, nṽ (n) = D 1 B 1 (B 1 1)n B D 2 B 2 (B 2 1)n B 2 1, so after substituting for D 1 and D 2 from equations (5.1) and (5.11), respectively, the optimal investment in the risky asset (in terms of n) becomes xˆπ (z) z=i( n) = x µ r σ [ λ O ( ) B1 1 ( ) ] B2 1 (B 1 1)(1 B 2 ) n n B r(r + λ O 1 B 2. (5.17) ) B 1 B 2 n b n b In particular, as n approaches n b, the point at which the individual annuitizes all her wealth, the amount invested in the risky asset approaches x 2r ( ) 1 µ r r 1, (5.18) r + λ O 18

19 independent of σ and λ S. Note that the expression in (5.18) is a multiple of the difference between the cost of the perpetuity and the cost of the annuity. In addition to the amount invested in the risky asset, it is useful to know how that amount changes as one s wealth changes. Note that the derivative of π (w, x) with respect to w has the same sign as the derivative of nṽ (n) with respect to n. Thus, the amount of wealth invested in the risky asset decreases with respect to wealth if and only if nṽ (n) + Ṽ (n) < for all n (n b, n ). (5.19) After some elementary algebra, we determine that (5.19) holds if λ S < r, while if λ S is sufficiently larger than r, then the amount of wealth invested in the risky asset increases with wealth, as we will see in the example in the next section Numerical Examples In this section, we present numerical examples to demonstrate the results of Section 5.1. We will calculate the probability of lifetime ruin ψ(w, x) in the presence of annuities with the corresponding probability ψ (w, x) when the individual cannot buy annuities, the problem studied in Young (24). From that work, we know that the probability of lifetime ruin ψ (w, x) is given by ψ (w, x) = (1 rz) p, for z < 1, z 1/r, (5.2) r in which z = w/x, and p = [(r 1 + λ S + m) + ] (r + λ 2r S + m) 2 4rλ S > 1. Also, the corresponding optimal investment in the risky asset π (w, x) is given by π µ r 1 rz (w, x) =, z 1/r. (5.21) σ r(p 1) Note that in this case, the probability of lifetime ruin is when z 1/r because when (relative) wealth is that large, then the individual can invest all her income in the riskless asset and fund her consumption with the earnings from that asset. Also, note that π approaches as z approaches 1/r. From (5.18), we know that π does not approach as z approaches ā(t) when life annuities are available in the market. Example 5.1, Constant Real Dollar Consumed: Suppose we have the following values of the parameters: λ S = λ O =.4; the hazard rate is constant such that the expected future lifetime is 25 years. 19

20 r =.2; the riskless rate of return is 2% over inflation. µ =.6; the drift of the risky asset is 6% over inflation. σ =.2; the volatility of the risky asset is 2%. c = 1; the individual consumes one unit of wealth per year. A = ; without loss of generality, we assume that annuity income is zero. It follows that the excess consumption x = c A = 1 and that z = w/x = w. The cost of the annuity is 1/(r + λ O ) = 1/.6 = \$16.6 6, while the cost of the perpetuity much larger at 1/r = 1/.2 = \$5.. In this example, D 1 = 13.4, D 2 =.2642, n =.81, and n b =.44. In Table 1, we give the probabilities of ruin ψ and ψ and the corresponding optimal investments in the risky asset, π and π, respectively. Table 1. Probability of Lifetime Ruin and Optimal Investment in Risky Asset w ψ(w, 1) π (w, 1) ψ (w, 1) π(w, 1) n.a There are a variety of interesting lessons that can be gleaned from the numbers in Table 1. First, for very low values of wealth, the probability of lifetime ruin is (obviously) close to 1%, but it is quite insensitive to whether or not annuities are available. Intuitively, the reason is that the costs of the annuity and the perpetuity are both relatively far from current wealth and are therefore probabilistically inaccessible. However, as the value of wealth increases, the probability of lifetime ruin declines, and the rate of probability improvement is much higher when the life annuity is available. In fact, as we get very close 2

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