Annuitization with Mortality Heterogeneity

This article examines the distributional implications of mandatory longevity insurance when mortality heterogeneity exists in the population. Previous research has demonstrated the significant financial redistribution that occurs under alternative annuity programs in the presence of differential mortality across groups. This article embeds that analysis into a life-cycle framework that allows for an examination of distributional effects on a utility-adjusted basis. It finds that the degree of redistribution that occurs from the introduction of a mandatory annuity program is substantially lower on a utilityadjusted basis than when evaluated on a purely financial basis. In a simple life-cycle model with no bequests, complete annuitization is welfare enhancing even for thosewith higher-than-average expectedmortality rates, so long as administrative costs are sufficiently low. These findings have implications for policy toward annuitization, particularly as part of a reformed Social Security system. Introduction Most public pension systems combine elements of redistribution and insurance. For example, the U.S. Old-Age and Survivors Insurance program (OASI) uses a nonlinear benefit formula that provides a higher replacement rate for lower-income workers in an effort to make the system progressively redistributive. At the same time, OASI insures individuals against longevity risk through the provision of benefits in the form of life annuities. For some types of risk, providing insurance and engaging in progressive redistribution are complementary activities. This is true, for example, with disability insurance. In the United States, workers covered by the DI program are provided with insurance against income loss in the event of becoming disabled. Because individuals who are disabled have, by definition, diminished earnings capacity, this same program serves a progressively redistributive role. Even on an ex ante basis, if lower-wage individuals Jeffrey Brownworks in theDepartment of Finance,University of Illinois atUrbana-Champaign and is a faculty research fellow at theNBER. The author is grateful to the Center for Retirement Research at Boston College for financial support and to two anonymous referees for helpful comments.