Risk Tolerance and Fixed Indexed Annuities - Why Rational Investors Will Prefer Annuities to Alternative Investments

This is a continuation of a series of posts that discuss a fixed indexed annuity study from Professor David Babbel.

Previous posts discussed the comparative performance of fixed indexed annuities and alternative investment options.  Comparative performance was examined over the past 15 years and over a longer-term timeframe.

This entry will consider incorporate risk tolerance into the performance comparisons.  As indicated in the following slide, Professor Babbel concludes that "many rational investors will prefer annuities to alternative investments."

These rational investors include moderately risk tolerant individuals who would generally prefer the annuities to the alternative investments, as well as those with higher levels of risk tolerance who would consider the annuities as part of a diversified portfolio.

As indicated in the following slides, the conclusions above are based on the relationship between expected utility and risk tolerance.  Utility, which is a function of the risk aversion coefficient, is on the vertical axis and risk aversion coefficient is on the horizontal axis. 

Generally, expected utility appears to decrease when the risk aversion coefficient increases.  

As seen in the following side, the 14 year annuity maintains its relative level of expected utility very well as the level of risk aversion increases.  The same cannot be said for the investment alternatives.

Results are similar for the 9 year annuity--again, demonstrating that any rational individual will choose the annuities over the investment alternatives.

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What exactly goes into the risk aversion coefficient? Also, how is expected utility determined. Overall super interesting article--thank you.