Optimal life insurance and annuity decision under money illusion

TL;DR

This paper models how money illusion affects optimal consumption, investment, and insurance choices in inflationary economies, revealing its impact on life insurance and annuity demand and contributing to the understanding of the annuity puzzle.

Contribution

It introduces a life-cycle model incorporating money illusion, showing its effects on financial decisions and explaining observed anomalies in annuity markets.

Findings

Money illusion increases life insurance demand among young adults.

Money illusion decreases annuity demand among retirees.

The model explains part of the annuity puzzle in inflationary contexts.

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.