Optimal Annuitization with Markov Regime Switching Model

We develop a new dynamic model of annuitization in which a Cobb- Douglas- type consumption-leisure utility maximizing individual receives non-traded constant labor income and has to decide on her allocation between a stock and a risk-free asset, as well as decide on the time when she enters full annuitization at one distinct point in time (around optimal retirement age). The distinct feature of the paper results from its consideration for a two-state regime-switching market environment. We analytically derive regime-dependent thresholds of wealth for annuitization and quantitatively identify the target annuitization wealth levels under the carefully chosen baseline parameter values. In particular, we find that the target annuitization wealth level is smaller in the Bull market than in the bear market, thus accounting for the reality that U.S. individuals opted for early annuitization in the Bull market as observed in the late 1990’s.