On Smoothing and Habit Formation of Variable Life Annuity Benefits

Abstract

This paper studies optimal consumption and investment strategies with lifetime uncertainty to design a smooth pension product. In a simplified Black–Scholes market, we investigate three strategies for consumption and investment: the classical strategy, the habit strategy, and the hybrid strategy. Incorporating additive habit formation in preferences leads to a request for less consumption volatility. Studying the consumption dynamics, it turns out that the hybrid strategy complies with the same preferences as the habit strategy. In our design of a smooth pension product, we are highly inspired by the consumption structure under the hybrid strategy and let consumption be specified as a time-dependent weighted average of last year’s consumption level and a standard market rate life annuity. We give two approaches for the investment portfolio. The numerical examples show that consumption under these approaches is less volatile than consumption under the classical strategy.