W W W . W A T S O N W Y A T T . C O M

Paying Out PensionsA Review of International Annuities Markets

Mike OrszagMike.Orszag@watsonwyatt.com

References

Paper by Mirko Cardinale, Alec Findlater and Mike Orszag

WW annuities website: http://www.watsonwyatt.com/annuities

James/Vittas study

INPRS websites

– http://www.inprs.org– http://www.pensions-research.org (Research

Network)

Outline

Review of key problems in annuities markets

UK System

Annuities in 12 other countries: Australia, Belgium, Brazil, France, Germany, Ireland, Italy,Netherlands, Portugal, Singapore, Spain, Switzerland

Issues

Definitions of annuities vary by country:

– US variable annuities as well as life insurance products in countries such as Japan with annuity payouts

Size of market often quite small

– Biggest life insurance companies in Italy pay no more than 1,500-2,000 annuities per year.

Annuities Problems

Demand is too low (people do not protect themselves against longevity risk unless forced to).

Supply is too high… but too low to meet what demand will be (suppliers do not use prudent assumptions but even so will not be able to replace state guarantees).

Annuities Problems – 6Ps

Perceptions – poor value for money

Processes – lack of advice

Products – lack of suitable products

Politics – pensions used for non-pensions purposes

Parameters – lack of data to price annuities and unrealistic assumptions

Portfolios – lack of risk management by insurers, sometimes due to regulatory issues or lack of supply of matching instruments.

Life Expectancy (Unisex)

Source: UN Population Data (2001)

Effective Retirement Ages

54

56

58

60

62

64

66

68

70

North America North Europe South Europe West Europe C/E Europe Japan

19501990

Source: Latullippe(1996)

Duration of Retirement (Years)

0

5

10

15

20

25

North America North Europe South Europe West Europe C/E Europe Japan

1950

1990

Source: Latullippe(1996)

The annuity premium

Though yield is low, annuities yield more for retiree than underlying non-annuitised investments in the same instruments.

Drawdown: An Alternative

Fund starts out at age 65

Consumption = Fund/Life expectancy

Consumption growth = return on fund – mortality rate

The Problem

UK Retirement Income

Basic state pension

Optional second state pension – contracted out benefits must be annuitised on single-sex, joint life basis with unisex tables

DB pensions – payments as index linked benefits (lump sum related to final salary)

DC pensions – annuitised before age 75 (option of drawdown before age 75) (lump sum of 25%)

75

98

132150

196

224

245

266

238227

0

50

100

150

200

250

300

350

1996 1997 1998 1999 2000

Corporate bonds Gilts

Source: Merrill Lynch and Prudential/M&G (Simon Pilcher)

Market size (£ billion)

Growth of the Corporate Bond Market

2.00

2.50

3.00

3.50

4.00

2001 2006 2011 2016 2021 2026 2031

2.00

2.50

3.00

3.50

4.00

2001 2006 2011 2016 2021 2026 2031

2.00

2.50

3.00

3.50

4.00

2001 2006 2011 2016 2021 2026 2031

2.00

2.50

3.00

3.50

4.00

2001 2006 2011 2016 2021 2026 2031

2.00

2.50

3.00

3.50

4.00

2001 2006 2011 2016 2021 2026 2031

Index Linked Yields

Australia Canada France Sweden UK USA

Real yield(% pa)

Source: Barclays Capital

Annuities in the UK

New business volumes in the UK annuities market (Source: Association of British Insurers)

Annuity Categories (plus Drawdown)

Level annuities

Escalating annuities

Index linked annuities

With profits annuities

Investment linked annuities

Income drawdown

Flexible annuities

Annuities Products in the UK

2001 New UK Annuity Business by Volume (Source: Association of British Insurers)

85.8%

8.3%

5.9%

Ordinary (Non-linked)

With Profit

Linked

Annuities Products in the UK

2001 New Internal Annuity Business by Volume (Source: Association of British Insurers)

91.8%

1.3%

6.9%

Ordinary (Non-linked)

With Profit

Linked

Annuities Products in the UK

2001 New External Annuity Business by Volume (Source: Association of British Insurers)

Perceptions

“It must be a scandal to be forced to hand over forever one’s hard-saved capital to an insurance company, which will pay a return, while you are alive, of currently less than a third of what it will earn on it. Why is the government so generous to insurance companies and extortionate to those who have saved for retirement” - A.M. Scriven (letter to newspaper quoted by Oonagh McDonald in “Income in Retirement: Are Annuities the Answer?”)

Perceptions

Belief of bad value for money:

Insurers exploit monopoly to

to charge consumers more

Government Policy of

Mandatory Annuitisation

Value for money of annuities

Internal rate of return on annuitiesNov. 26, 1999

The Annuity Margin

Term structure

Market AnnuityRate

Mortality

Assumptions

The Annuity Margin

The annuity margin is the difference between the term structure and the implied term structure. Interpretation is margin as function of assets under management

The Annuity Margin

Reduction in Yield (Annuity Margin) of Level Male Life Annuities (%)Week ending 28 April 2000

Purchase Price £10,000 Purchase Price £100,000PopulationMortality

AnnuitantMortality

PopulationMortality

AnnuitantMortality

Age 65 1.22 0.29 0.92 -0.01 Age 70 1.96 0.65 1.74 0.44 Age 75 3.09 1.23 2.84 0.98

Notes: Calculations use the industry average annuity rate and the term structure ofyields on UK government bonds.

Australia

No compulsion but tax incentives because of means tested benefits

Superannuation system – 80%-90% paid as lump sums.

Virtually no life annuities market – under US$100m

Allocated annuities (A$4.5bn), relatively concentrated market

Significant term market (A$2bn) – terms up to 20 years

Belgium

Replacement ratios from state system around 50%. Roughly 40% covered by private sector DB plans.

Occupational pensions pay out lump sum, term of life annuities. Lump sum has tax advantages – after 1985 occupational plans switched to paying out lump sums.

Most plans are profit sharing of interest and mortality, fixed annuities uncommon.

Brazil

Occupational sector with R$171bn in assets

Occupational pensions pay annuities which are indexed linked. Some plans offer partial lump sums.

Personal pensions – participating annuities with index-linked guarantees.

New VGBL product combines life insurance with annuity payment on retirement.

France

Loi Madelin plans for self-employed – must be annuitised

Low penetration of traditional products.

Most products offer investment-risk sharing

New products: unit-linked, guarantees.

Germany

Occupational pensions – most payments are in terms of annuities.

Most private products are deferred with-profit products.

Riester reforms of 2001 – annuitisation required eventually, 20% of capital may be taken as lump sum.

Ireland

Occupational DB pensions – annuitised except for lump sum (British model)

Personal pensions – after 1999, lump sum after guaranteed pension of 12700 Euros. Income drawdown fund as alternative until age 75.

Nonprofit annuities most common.

With profit and impaired life annuities still available.

Italy

50% mandatory annuitisation of new second pillar funds (1993 law). Tax incentives for further annuitisation.

Single premium annuities rare in Italy.

Most common annuities offer investment profit sharing – mortality profit sharing not allowed.

Virtually no market for fixed nominal annuities

Life insurance annuity options common but rarely exercised.

Netherlands

85% of workers covered by occupational pensions.

Compulsory annuitisation for both occupational pensions and third pillar arrangements.

Deferred annuities quite common for DC occupational arrangements

2/3 of market for personal pension annuities is with profits, 1/3 unit linked.

Portugal

2/3 of occupational and many personal pension funds must be annuitised.

Coverage of occupational plans low – 3.6% of workforce.

Profit sharing annuities prevalent.

No unit-linked or index-linked annuities.

Singapore

Minimum Sum Scheme

Flat rate annuities prevalent

About 20% of population buys annuities.

Lack of long duration securities poses problems

Spain

No compulsory annuitisation

Low coverage of occupational schemes.

Higher coverage of voluntary schemes but contributions are low – assets of third pillar only 25bn Euros.

DB occupational plans typically taken as annuities.

Bulk annuities common.

Some advantage for low income individuals to buy annuities from DC plans.

Non-profit annuities.

Switzerland

Annuitisation normally required for mandatory occupational pensions.

Majority of voluntary arrangements paid as lump sums.

Bulk contracts common – optional index-linking.

Voluntary annuities – capital guarantees.

Summing Up

Different annuities models:

– Continental European (with profits with technical interest rate)

– British (non-profit annuities)

Both models have significant problems.

Annuities Problems – 6Ps

Perceptions – poor value for money

Processes – lack of advice

Products – lack of suitable products

Politics – pensions used for non-pensions purposes

Parameters – lack of data to price annuities and unrealistic assumptions

Portfolios – lack of risk management by insurers, sometimes due to regulatory issues or lack of supply of matching instruments.