Social welfare effects of annuitization in small open economies

Abstract This paper develops a theory of when annuitization improves or reduces social welfare. The analysis is based on a small open economy with exogenous prices, populated by overlapping generations of non‐altruistic agents. Annuities provide longevity risk insurance and above‐market returns, but also reduce accidental bequests that transfer resources from the old to the young. I show that the welfare trade‐off between these channels is governed by the interest rate: above a threshold, the cost of reducing bequests dominates and no annuitization is socially optimal; below it, partial annuitization improves welfare. Socially optimal allocations can be implemented by mandating a savings portfolio with a predetermined share invested in annuities. Governments that instead mandate annuities through fully funded pensions cannot replicate these allocations, even when annuity markets are missing and agents cannot borrow against future benefits. Although derived for small open economies, the results provide a benchmark for identifying when annuitization raises or lowers welfare and presumably extend to closed economies, where the boundary may still depend on the rate of return but now through threshold values of the parameters that determine it.