Discussion Papers, Department of Business and Management Science, Norwegian School of Economics (NHH)
Trond M. Døskeland
Optimal Pension Insurance Design
() and Helge A. Nordahl
Abstract: In this paper we analyze how the traditional life and
pension contracts with a guaranteed rate of return can be optimized to
increase customers’ welfare. Given that the contracts have to be priced
correctly, we use individuals’ preferences to find the preferred design.
Assuming CRRA utility, we cannot explain the existence of any form of
guarantees. Through numerical solutions we quantify the difference
(measured in certainty equivalents) to the preferred Merton solution of
direct investments in a fixed proportion of risky and risk free assets. The
largest welfare loss seems to come from the fact that guarantees are
effective by the end of each year, not only by the expiry of the contract.
However, the demand for products with guarantees may be explained through
behavioral models. We use cumulative prospect theory as an example, showing
that the optimal design is a simple contract with a life-time guarantee and
no default option.
Keywords: Household Finance; Portfolio Choice; Life and Pension Insurance; Prospect Theory; (follow links to similar papers)
JEL-Codes: G11; G13; G22; (follow links to similar papers)
22 pages, October 18, 2006, Revised June 21, 2007
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