Health State Transitions and Longevity Effects on Retirees’ Optimal Annuitization

Abstract

The interplay between longevity risk and health state transitions for retirees’ optimal annuitization decisions is investigated. Using a life-cycle framework incorporating wealth levels, bequest motives, and consumption floors created by government subsidies, we examine how increased longevity in conjunction with an individual's health state transition process impacts annuity purchase decisions. Health state transition matrices are estimated from the Health and Retirement Survey (HRS) data. The effects of increased longevity on annuitization decisions are considered when longevity is both accompanied by increased time spent in healthier states (morbidity compression) or experienced by more time in unhealthy states (morbidity expansion). We find that retirees’ annuity demand is affected by wealth, initial health status, and expansion or compression of morbidity. Wealthier retirees have higher annuity demand when health shocks are considered, and increased longevity increases demand even more when retirees expect an expansion or slight morbidity compression. With health shocks and expectations of severe morbidity compression considered, the opposite effect might occur. Thus, an annuity can help retirees hedge health shock costs when slight compression or expansion of morbidity occurs. For retirees with lower wealth, the consumption floor provided by governmental subsidies will create a decreased propensity to annuitize.