Annuities Markets and Policy Issues in Reformed Social

Security Systems

by

Estelle James

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Why are annuity markets important?

• Annuities market small, little known in most coutnries--but will grow as funded social security systems with individual accounts grow

• Pensions reforms with funded accounts in many countries; under consideration in US

• First stage of pension reform--accumulation Second stage--payouts, including annuities

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What is an annuity?

• Each person’s lifetime is uncertain and may run out of money before death.

• Annuities take large premium and turn it into fixed income stream until death-- longevity and investment insurance

• If expected lifetime is higher, monthly payout is lower

• Many types with added protection and cost

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Voluntary annuity markets are small because:

• Myopia and lack of understanding

• Annuitization increases some risks: People want liquidity and flexibility for emergencies, bequest for family if die early

• Crowd-out by social security, employer-sponsored pensions, family system

• Adverse selection--people who expect long lifetimes buy annuities, make price too high for those with lower lifetimes (important only if risk differentiation is not possible)

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Policy issues regarding payouts when social security is

reformed• 1. Should annuitization be mandatory or

voluntary? What other payout forms should be used?

• 2. What types of annuities are possible and what types should be allowed? Should joint annuity, price-indexed annuity be required? Should variable annuities be allowed?

• 3. What are the permissable categories for risk categorization?

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Policy issues (Cont’d)• 4. How cost-effective is annuity provision by

insurance companies? • 5. Should specialized or general purpose

insurance companies be used?• 6. Should retail or group market be used?• 7. Should price be controlled? • 8. What information should be disclosed?• 9. Other regulatory issues• 10. What steps must be taken to prepare for

annuity markets?

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1. Should annuitization of Pillar 2 savings be mandatory

or voluntary?• Rationale for mandatory savings is that people

are myopic, may not save enough for their old age and may live in poverty or become charge on public treasury--moral hazard problem

• Myopia may still exist at age 65, although perhaps not as much. Therefore important to make sure they don’t spend all their savings too quickly. Limits on speed of withdrawal important.

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Dilemma: Pillar 2 savings are person’s “property” but

restrictions turn it into “tax”• Many legitimate reasons for not wanting to

turn entire savings into fixed income stream

• Solution: Make sure each person annuitizes enough to keep him/her out of poverty

• Large Pillar 1 allows more discretion re Pillar 2

• Savings beyond poverty line can be more discretionary--e.g. gradual withdrawals

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What do countries with mandatory savings do?

• Annuitization is mandatory in Hungary, Poland, Sweden--although may not be necessary because large Pillar 1

• Annuitization mandatory beyond age 75 in UK and 5 years after retirement in Argentina (new)--market timing problem

• Gradual withdrawals permitted in Australia, most of Latin America--may lead to moral hazard problem if Pillar 1 is means-tested

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2.What forms of annuities are available and which should be permitted?

• SPIA--single premium immediate annuity: you pay today and annuity begins. Largest amount.

• Deferred annuity--you pay today but annuity begins 5-10 years later; allows gradual purchase

• Annuity with 10 or 15 year guarantee--your estate collects even if you die. Good for unhealthy and those who want to leave bequests. Monthly amount less but expected lifetime amount similar.

• Joint annuity--after your death specified beneficiary (spouse?) collects some %. Supports dependents, prevents poverty among old women.

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Annuity types (Cont’d)• Nominal v. price-indexed annuity that goes up

with inflation. Latter maintains real purchasing power, but insurance company charges for this--can’t hedge against inflation. Should government issue indexed bonds? Should companies provide partial indexation?

• Each extra protection costs, reduces monthly payout; policy-maker must consider trade-offs. Inflation indexation costs the most. Shouldn’t require unless government matches with long term indexed bonds or sets caps.

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Table 1: Monthly Annuity Pay-Outs for Immediate Annuities at Age 65 ($100,000 premium)

A. Male-Nominal

Canada US Australia UK Switzerland Singapore Level SPIA 740 733 700 727 590 10YG 702 658 691 571 650 Joint SPIA 664 648 543 642 501 (600) Escalating SPIA 564

B. Male-Price Indexed

Israel UK Chile Immediate

annuity Managers insurance

Deferred annuity

Level SPIA 522 820 625 642 10YG 761 584 600 Joint SPIA 438 731 (663)

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Fixed v. variable annuities?

• Fixed annuity gives fixed income stream, like investment at government bond rate. But payout depends on bond rate on date of annuitization--retirement date risk. Gradual purchase over several years may be preferred. Inflation risk if not indexed.

• Variable annuity varies with investment return and/or cohort longevity. Allows payout to increase with markets. Investment risk increases but retirement date risk falls. Does it provide partial price indexation?

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What do countries do? • Switzerland, Chile, Israel--joint annuity (60% to

survivor)• Chile, Israel, Hungary--indexed annuity.UK--

indexed up to 5% annual inflation • Singapore--individual, nominal, 10-15 year

guarantee. Variable annuities popular• Argentina--joint, nominal, variable with 4%

annual return as floor• Were costs v. benefits carefully thought out?

Limitation on product form helps consumers compare price, but choose forms carefully

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3. What are allowable risk categories?

• Insurance companies learn how to put people into different risk categories and charge different prices--gender, age, behavior

• Induces good risks to buy and provides good incentives--avoids adverse selection, moral hazard, redistribution

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Risk categories for annuities• Gender, race, income, occupation, health, family

history, DNA, could be used to predict longevity, determine categories

• This may benefit vulnerable groups (poor, uneducated, sick), who die young, subsidize better-off groups if in single pool. If differentiated they get better terms, less adverse selection, greater annuity purchase

• But differentiation may violate social norms, privacy. Social dilemma: Which categories should be allowed?

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What do countries do?• Can income, gender, race, DNA. etc. be used?

Varies by country’s norms.

• Gender-specific tables used in Israel, Chile, Hong Kong, Australia, Switzerland Pillar 3. Unisex tables required in Hungary, Poland, Argentina (new), UK, Switzerland Pillar 2. This redistributes, may lead to creaming, but keeps older women out of poverty.

• In UK special rates for health impaired

• Insurance companies will develop new risk categories, if allowed

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4. How effectively do insurance companies provide annuities?

• One measure: compare premiums paid in with total lifetime annuity payouts--money’s worth ratio (MWR)– discount future payouts to get present value – reduce by probability that you die, don’t collect– this gives EPDV--expected present discounted value

of annuity

• MWR = EPDV/initial premium paid in. Annuity is good for consumers if MWR=100% --get back premium+longevity insurance

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Calculations of MWR in several countries

• I calculated MWR using government bonds rate as discount rate, country mortality tables, two longevity groups--annuitants (high longevity) and population (average)

• I found MWR for annuitants near 100%, sometimes > 100%; for population > 90%

• Average annuitant gets government interest rate + longevity insurance

• Lower MWR for price-indexed annuities.

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Money’s Worth Ratio (MWR) with Risk-Free Interest Rate (as %) – Males, Age 65,

A. Nominal

Canada US Australia UK Switzerlandb Gen.P Ann.P. Gen.P Ann.P Gen.P Ann.P. Gen.P Ann.P. Gen.P Ann. P

Level SPIA 92.7 98.2 85.8 97.4 92.8 103.5 91.2 98.3 91.4 108.2 B.Price Indexed

UK Chile Israelb Gen.P Ann.P. Gen.P Ann.P. Gen.P Actuaries

Committee Legally

Required Managers’ Insurance-

ACommittee

Deferred ACommittee

Level SPIA 74.4 80.1 85.4 95.4 76.9 88.2 85.2 90.6

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How do insurance companies cover their costs if MWR=100%?• They invest premium in mixed portfolio--public

& private bonds, equities, mortgages• They earn risky rate, pay annuitants risk- free

rate: cover their costs and profits out of spread (1-2%) between two rates

• Risk to annuitant is reduced by: investment diversification, hedging, negatively correlated risks among insurance products, reinsurance and guarantee funds, company stockholders bear losses, bankruptcy laws protect annuitants

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So annuity market works well

• For annuitant who wants fixed income stream and is satisfied with risk-free rate

• Doesn’t work well for worker who knows he is sick and wants to leave bequest, prefers flexible income for emergencies, wants indexed annuity, or is willing to accept greater risk for greater return

• Also doesn’t work well if insurance companies are unsafe, promises aren’t kept--so careful regulation needed

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5. Specialized or general purpose insurance companies?• Specialized organizations easier to monitor,

requires asset segregation, prevents hidden cross-subsization to or from annuitants

• But limit benefits from negatively correlated risks (life v. annuities), cost more

• In most countries general purpose companies used and assets not segregated but differential liability stream implicitly taken into account. Regulation difficult.

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6. Group annuities v. retail market• Retail--individual and insurance company seek

eachother out, market sets price

• In group market, system negotiates group price with limited number of companies and products (competitive bidding)--reduces choice and marketing costs

• So far most reforming countries use retail market although those built on employer-sponsored plans may use group market

• Sweden uses public agency with single community pool (public control over assets)

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7. Are price controls desirable?

• Regulator might choose wrong price and won’t change price with interest rates; better to let market set, although group contract may be preferable

• Switzerland sets annuity conversion factor at 7.2% of retirement savings for joint annuity--has not changed since 1985, losses for companies since interest rate has fallen

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8. Information

• Important to distribute price information to consumers to enable comparisons. Aided by product standardization, internet.

• Singapore--Every 6 months Central Provident Fund collects price and product information and distributes. Has one of lowest costs, highest values.

• Argentina has much variety, no transparency, difficult to compare costs and values

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9. Regulatory problems:• Cohort mortality tables for population don’t exist• Annuitants are select group with higher longevity--

little data and selection changes as policies change• Future mortality improvements unknown; likely to

be high due to catch-up in developing countries• Long term financial instruments unavailable so

difficult to match assets to liabilities • Future interest rates unknown, reinvestment risk high • Future inflation unpredictable and indexed bonds

unavailable; price-indexed annuities not credible • Companies may expand now, problems show up later

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Conclusion

• Long planning horizon is necessary

• Fill in gaps in financial instruments, collect data for mortality tables, building regulatory expertise--takes many years

• Many trade-offs, must be thought through carefully--especially important if funded DC pension plan is adopted: begin planning payouts soon after accumulation begins.