Optimal life insurance and annuity decision under money illusion
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ID: 283523
2024
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Abstract
This paper investigates the optimal consumption, investment, and life
insurance/annuity decisions for a family in an inflationary economy under money
illusion. The family can invest in a financial market that consists of nominal
bonds, inflation-linked bonds, and a stock index. The breadwinner can also
purchase life insurance or annuities that are available continuously. The
family's objective is to maximize the expected utility of a mixture of nominal
and real consumption, as they partially overlook inflation and tend to think in
terms of nominal rather than real monetary values. We formulate this life-cycle
problem as a random horizon utility maximization problem and derive the optimal
strategy. We calibrate our model to the U.S. data and demonstrate that money
illusion increases life insurance demand for young adults and reduces annuity
demand for retirees. Our findings indicate that the money illusion contributes
to the annuity puzzle and highlights the role of financial literacy in an
inflationary environment.
| Reference Key |
wei2024optimal
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| Authors | Wenyuan Li; Pengyu Wei |
| Journal | arXiv |
| Year | 2024 |
| DOI |
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