The Distribution Phase of an Individual Accounts Reform of Social Security: The Potential Role for Private Sector Annuities. G. A.

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1 The Distribution Phase of an Individual Accounts Reform of Social Security: The Potential Role for Private Sector Annuities G. A. (Sandy) Mackenzie

2 THE DISTRIBUTION PHASE OF AN INDIVIDUAL ACCOUNTS REFORM OF SOCIAL SECURITY: THE POTENTIAL ROLE FOR PRIVATE SECTOR ANNUITIES G.A. (Sandy) Mackenzie March 19, 2002 I. Introduction The retirement of America s baby boom generation over the next 20 years and the increasing life expectancy of its members will strain social security s finances. Although there is inevitably some debate over social security s long-term prospects, and over how quickly the system s finances will deteriorate, a consensus has emerged that the current surpluses of payroll tax revenue over benefits will turn to deficits before too many years have passed. 1 Under the intermediate projection set out in the 2001 Annual Report of the OASDI Board of Trustees, the increase in benefit expenditure entailed by aging baby boomers will eliminate the surplus by 2016, and exhaust the OASDI trust fund s accumulated reserves by The system s finances are projected to deteriorate further in the following three decades. 3 Visiting Fellow, Urban Institute, and Western Hemisphere Department, International Monetary Fund. I am indebted to Rudy Penner, Larry Thompson, Emil Sunley, Adam Carasso, and Elizabeth Miranda for their comments on an earlier version of this paper. I also wanted to acknowledge helpful discussions with Gene Steuerle on the issues the paper surveys. I alone am responsible for any errors in the paper. The views it expresses are my sole responsibility and do not necessarily represent those of the IMF or IMF policy. Similarly, its views do not necessarily reflect those of the staff, trustees or advisory groups of the Urban Institute or any organizations that provide financial support to the Institute. address: gmackenzie@imf.org. 1 Those workers who will be joining the ranks of the retired or the labor force in the next quarter century have almost all been born, so their numbers are predictable with some accuracy. 2 Board of Trustees, OASDI Trust Funds The definition of the surplus excludes interest payments by the Federal Government on the debt held by the trust funds from the measure of income. 3 Relatively modest differences in assumptions regarding birth and death rates, inflation, and real wages growth have markedly different impacts on financial simulations, as is illustrated by the 75-year simulations carried out for the Board of Trustees. In the high-cost scenario, expenditure rises from 10.5 percent of payroll in 2000 to 12.6 percent by 2020, and to 27.9 percent by In the low-cost scenario, the expenditure ratio rises to 13.0 percent by 2020, but reaches only 13.9 percent in 2075.

3 2 Given the trend in social security finances, it is hardly surprising that there is general agreement that the system needs to be reformed to put its finances on a surer footing, and for other reasons as well. Broadly speaking, there are two types of reform proposals on the table. The first involves changing the parameters of the existing system, but not its fundamental structure. Most reform proposals of this genre call for measures that would reduce the growth of lifetime benefits of workers contributing to the system, by, for example, indexing insured earnings to the CPI instead of wages, or lengthening the contribution period. The second type of reform proposal usually includes some measures of this type, but is based on a more fundamental reform involving the introduction of individual accounts. The addition of individual accounts to the existing system (an add-on reform) reduces the relative importance of the social security benefit as a source of income in retirement. Moreover, the replacement rate provided by the social security benefit will decline in the light of the measures that will be taken to arrest the deterioration in the system s finances. A fortiori, an individual accounts reform in the shape of a carve-out will require an even larger cut in benefits over time, since it involves a reduction in the rate of the payroll tax (or a diversion of part of the payroll tax) to finance individual accounts. 4 With lower payroll tax revenues, the restoration of social security s financial balance will require a greater cut in average benefits. The possibly sizeable reduction in the value of social security benefits that may result from social security reform raises some complex and sensitive policy issues. The old-age retirement benefit provides valuable insurance against both inflation and longevity risks, since it is both payable for life and indexed to the CPI. U.S. financial markets do not now provide annuities with both of these features. 4 A carve-out reform finances the contributions to the individual accounts by channeling part of the payroll tax rate (2 percentage points in most proposals) into individual accounts. Hence, less money goes to pay for social security benefits. An add-on simply creates a separate compulsory individual accounts contribution. 2

4 3 The debate over the merits of an individual accounts reform, focused hitherto on the accumulation phase of the pension cycle, needs to discuss the need for restrictions on withdrawals from individual accounts, and in particular their partial or complete annuitization. The policies that might govern withdrawals range from complete or near-complete laissez-faire (i.e., no restrictions on withdrawals with the possible exception of a requirement that the account holder have reached the age of eligibility to make withdrawals) to the compulsory annuitization of all of the funds in the form of a life annuity supplied by the government. In between these poles lie many intermediate positions. They differ mainly as regards the extent of annuitization and the role of the public sector in providing the annuity if annuitization is required. The aim of this paper is to identify and analyze the basic questions that must be resolved to formulate a well worked-out policy for the distribution phase of an IA reform, assuming that such a reform is implemented. 5 The discussion has already alluded to two fundamental questions. Should there be restrictions of any kind on withdrawals, including a requirement to annuitize some or all of the funds in an account? If so, should the public or the private sector provide the annuity? Answering these questions entails wrestling with basic philosophical issues like the role of the state in the economy and the appropriateness of restrictions on individual choice. Providing an informed answer to both of them requires addressing a lengthy list of more specific questions, however. What follows is intended to give the flavor of these more specific issues. Extent of Annuitization and Form of Annuity. 5 The paper does not discuss the overall merits of an individual accounts reform. For such a discussion, see Barr (2000), Cordes and Steuerle (1999), Munnell (1999), and Samwick (1999). See also Steuerle and Carasso (2001) for a discussion of possible compromises between advocates of individual accounts and others. 3

5 4 Social security offers a retiring worker an indexed life annuity, and provides separate benefits for his family members for various contingencies or eventualities. The worker cannot opt to receive all or even part of the wealth represented by his social security benefit in the form of a lump sum. However, annuitization of the funds in an IA need not be a matter of all or nothing. Presumably, the optimal degree of annuitization of a retiring worker s wealth is greater than zero and less than 100 percent, although this will not be true for everyone, and notably not for the terminally ill. 6 The rule that determines the extent of annuitization of the funds in an individual account should ideally balance the risks of over and under annuitization. Above all, it should not leave the worker exposed to a serious risk of outliving his resources. A closely related decision is whether the mandatory annuity should be an indexed simple life annuity, or assume some other form. Given the fact that even the reduced social security benefit implied by most proposals is estimated to account for more than two times the value of the annuity that the individual account will fund, less than full annuitization may well be justifiable. Safety Net and Distributional Issues. An individual accounts reform raises important questions about the role of the IA in the social safety net. In particular, the question arises whether and to what extent the value of the funds in the account should be guaranteed. Should IA holders who have failed to save enough to finance the minimum annuity required of them have their account topped up, for example, or should they be handled by the existing safety net the Supplementary Security Income Program (SSI)? A related issue is the potential impact of an individual accounts reform on the redistributive features of social security. The adoption of an annuity form other than the single life annuity also has implications for the form of the benefits for family members. Issues Arising from Privatization of the Provision of Annuities 6 Worker is used throughout the paper to refer to all contributors to social security, including the selfemployed. 4

6 5 Premium differentiation and variability. The life annuity that social security provides is the same for male and female workers with identical earnings histories. Life insurance companies, currently the only financial institutions that may underwrite annuities in the United States, charge a female annuitant a higher premium than they charge her male coeval for a given income stream, because the average woman lives longer than the average man. If annuity provision is privatized (and conceivably even if it isn t) the question arises whether such differentiation is to be allowed. Premiums also vary over time, because of changes in interest rates. Again, the question arises whether this is desirable and if it isn t, whether its effects can be mitigated. Regulatory, tax, and administrative issues. Privatization also makes the consequences of insurance company failure more serious. Perhaps the current framework of financial regulation and supervision is not adequate for an enlarged annuities market, especially if it takes on the character of a public good. Should the government provide a guarantee of some kind to protect annuitants from the failure of their annuity provider, if it requires the purchase of annuities? The privatization of annuities provision will also bring into relief the differences in the tax treatment of social security benefits and private annuities. Finally, a host of administrative and sequencing issues arises if the private sector takes on a bigger role in the provision of annuities. The paper proceeds as follows. Given the potential role of the private sector in the provision of annuities, Section II is devoted to a review of the relevant features of the market for private sector annuities and the operation and regulation of life insurance companies. Sections III, IV, and V, which together are the heart of the paper, then address more fully the series of questions laid out in this section. In particular, Section III discusses the pros and cons of mandatory annuitization, rules for determining how much, if any, of the funds in an individual account should be annuitized, and the form the annuity should take. Section IV discusses the implications of an individual accounts reform for the social safety net, while Section V takes on the various issues that arise if the provision of the mandatory annuity is privatized. Section VI sums up. 5

7 6 To allow the paper to focus on policy matters, some important background information is relegated to two appendixes. Appendix 1 summarizes the basic features of the U.S. social security system and is intended as a reference for the reader who is not familiar with its structure. The paper refers to a number of plans to introduce a system of individual accounts and to the findings of the President s Commission to Strengthen Social Security. Appendix 2 summarizes the most relevant of their provisions and recommendations, so that the reader can see for himself how these plans have tackled the issues surrounding the distribution of the funds that accumulate in individual accounts. II. Annuities Markets and Their Regulation in the United States Basic Features of Annuities Markets and Influences on the Demand for Annuities U.S. financial markets offer many different kinds of annuities, although the size of the annuities market as a whole is modest in comparison with that of other financial assets. The variable annuity, which combines features of a savings plan with an equity mutual fund, is by far the most important part of the market. If the account holder chooses to annuitize (which is not a common choice), he may elect to allocate some of the accumulated funds to a fixed account, and some to a variable account. The first provides a nominally fixed income, and the second an income that depends on financial market performance. Sales of variable annuities in 1999 are estimated to have amounted to $122 billion (about 1¼ percent of GDP). Sales of fixed annuities amounted to $37 billion, or roughly $19,000 per person reaching the age of 65 in The single payment immediate fixed life annuity which in return for a single payment provides a stream of payments fixed in dollar terms that commence upon purchase and are paid for as long as the purchaser (annuitant) lives or in the case of an annuity with a joint 7 This figure does not give the average value of fixed annuities sold in A relatively small share of the cohort of 65-year-olds would have bought one. 6

8 7 survivor, for as long as either he or his spouse remains alive is not popular with individuals. Sales to individuals amounted to only $2 billion in The small size of the market for life annuities in the United States is by no means unusual. In most countries, including those with well-developed financial systems, annuities markets are small, if they exist at all. The only exceptions to this general pattern are Chile, Singapore, and a few other countries where the introduction of individual accounts has included measures to encourage or require the conversion of the funds in individual accounts into life annuities. Such measures explain in part why the annuities market in the United Kingdom is relatively larger than the U.S. market (Mackenzie 2002). Economists offer five explanations for the apparent lack of interest in individual life annuities. 9 Specifically, the demand for life annuities may be inhibited by (1) the substitutes provided by social security benefits and employer pensions; (2) the desire to leave an inheritance (the bequest motive); (3) the need to anticipate unexpectedly large expenditures; (4) the impact of adverse selection on annuity premiums; and (5) the shortsightedness of potential annuitants or their lack of understanding of an annuity s properties. These are plausible explanations. If a worker is eligible for both the social security benefit and a company pension, it is likely that a large share of his wealth will be annuitized upon retirement. A recent study found that annuitized wealth, including the estimated capitalized value of private pensions and accrued social security benefits, accounted for 52 percent of average net wealth of a sample of Americans age 51 to 62. For the bottom 5 percent of this group by wealth the ratio was estimated to be 195 percent, of which 179 percentage points were accounted for by social security (Gustman et al. 1997). Another indication of the importance of social security for low- 8 The estimates of annuities sales in 1999 come from a web site called insure.com-annuities, which refers to LIMRA international. The figure for life annuity sales in 1998 is from the American Council of Life Insurers, and is cited by Brown and Warshawsky (2001). It excludes sales of group annuities. 7

9 8 income Americans is that it accounts for over 80 percent of the income of the lowest two quintiles of households ranked by income with a member aged 65 or older (Social Security Administration 1998). 10 The share of income that social security provides to the elderly living below the poverty threshold declines somewhat to 70 percent because of the relatively greater importance of Supplemental Security Income (SSI) and other assistance in the income of the poor. The wish to leave a legacy may also deter annuitization. When an individual buys a single life annuity, her premature death deprives her heirs of all or most of the wealth represented by the premium. It also leaves her less prepared (although not necessarily ill prepared) to deal with unexpected but necessary outlays, such as costly medical care. Adverse selection affects the market for life annuities because the life expectancies of annuitants exceed those of the general population, which increases the premiums life insurance companies charge for annuities, raising their cost to the typical person. The purchase of a life annuity may seem like a bad bargain quite apart from the impact of adverse selection and other influences on cost, since it involves an irredeemable up-front payment of a large sum of money in return for a stream of income of uncertain duration. Unlike most other financial assets, the holder cannot have her cake (encroach on the capital) and eat it (earn interest) too. Even if annuities are a good investment, they will appear unattractive to anyone who discounts future income at a high rate. Nonetheless, these explanations, with the possible exception of the first, are not entirely satisfactory. In principle, the typical person should benefit from owning a life annuity unless his or her wealth is already substantially annuitized, since annuities can provide valuable longevity 9 Walliser (2001) provides a comprehensive analysis of the economics of annuities, from which this paper has drawn. 8

10 9 insurance; that is, protection against the risk of outliving one s resources because of unexpectedly long life, fecklessness, or bad investments. 11,12 Adverse selection, interest rate uncertainty, costly financial intermediation, a desire to leave a legacy, and shortsightedness are all facts of life. They would presumably reduce the amount of wealth an individual would devote to an annuity, but they need not reduce it to zero. Annuities retain their property as longevity insurance, even if the terms are not as good. Provided the load factor is not excessive, a life annuity will carry a higher rate of return (while the annuitant is living) than a fixed-income security does. In addition, an annuity can benefit the annuitant s heirs by reducing the likelihood that he will become a burden on them by living long or spending recklessly. The purchase of an annuity reduces the maximum bequest an individual could leave, but depending on its terms has relatively little effect on the expected value of the bequest. 13 It is not irrational or foolish for a person to buy an annuity while at the same time she plans to leave a bequest, particularly if she has good reason to believe she will live a long life. Shortsightedness could blind one to an annuity s attractive features, but not everyone is shortsighted These two sets of statistics are hard to compare, not simply because wealth is a stock and income a flow, but also because the income in kind from real estate would not be included in the measure of income, which includes only monetary income. 11 If human capital is included in the measure of personal wealth, most individuals do have a substantial share of their wealth annuitized during their pre-retirement lives. 12 Starting from the assumption of perfect financial markets costless financial intermediation and making a few other simplifying assumptions, it is possible to show that in the absence of a bequest motive an individual will not only acquire annuities but will devote all his wealth to that end. (Yaari (1965) is the source of this insight.) The reason for this theoretical dominance of annuities over other investments is that the return an annuitant gets on his investment, provided he lives (his conditional return) will always exceed the rate of interest. The insurance company pools the premiums of all its annuitants, investing them at the market rate of interest. Because the probability of all of them surviving from one period to another is less than one, the insurance company can offer an annual income with a conditional rate of return that exceeds the market rate of interest. Other than the assumption of costless financial intermediation, the assumptions underlying this argument are no uncertainty regarding interest rates; no lumpy expenditures; and life expectancies (the probability of dying in any given period) that are known and the same for all members of the population. 13 The annuitant can hedge against the consequences of early death by buying a certain and life annuity, which makes payments for a stipulated period (e.g., 10 years) or until the annuitant s death, whichever period is the greater. 9

11 10 Recent research has tried to gauge the effect of adverse selection and other influences on the attractiveness of annuities in the United States. This work aims to calculate what a given age group gets back in present discounted value terms for every dollar it invests in life annuities. It starts by estimating the number of members of a cohort of annuitants of a given age when they purchase the annuity who will be alive 1, 2, 3,.n years later based on projected survival rates. Given the fixed value of the annuity payment, these calculations determine the value of payments that will be made over the course of the postretirement lifetimes of the annuitants. The payments thus projected are then discounted back to the time of retirement, normally using government bond rates as the discount factor. Typically, the ratio of this present discounted value to the premium, which is dubbed the money s worth ratio (MWR), is less than one. 15 Were it not so, the insurance company would be losing money (unless it could invest the premiums at a rate that exceeded the discount rate). One important finding of recent studies is that MWRs for annuitants consistently exceed those of the general population. For example, Mitchell et al. (1999) estimated that the MWR for a 65- year-old female from the general population in the United States is.829; the MWR for a 65- year-old female annuitant is.893 (see table). As would be expected, lower figures are obtained when a representative corporate bond rate is used. These studies shed a great light on the importance of adverse selection. If the difference between the MWR for the general population and that for the annuitant population reflects the impact of adverse selection, then they show that it accounts for a substantial share of the load on 14 Indeed, the unattractiveness of private annuities may make some individuals excessively cautious, so that they spend much less of their savings than they could afford to. 15 The numerator of the MWR is the present discounted value of the future stream of payments weighted by the probability that the annuitant survives to receive them. The numerator is thus given by the n i A π /( 1 + r ) i expression i = 1 where A is the fixed payment, n is the maximum number of years an individual survives after purchase of the annuity, r is the (assumed constant) rate of interest and A i is the probability the individual survives to the ith year after retirement. The denominator is the value of the premium. 10

12 11 an annuity for the population at large. Other influences may be at work, however, as Walliser (2000) has pointed out. In the United States, and probably other countries, the higher an individual s income, the longer he or she tends to live. If the demand for annuities is normally related to income, annuitants will tend to be longer-lived. Even in the case of the population of annuitants, however, a given cohort appears to be getting back no more than 90 cents on the dollar, implying a load factor of about 10 percent. Economists have not succeeded to date in making a detailed decomposition of the load factor. Part of it represents the administrative costs that insurance companies incur in making monthly payments and maintaining individual files. Life annuities should not require the same amount of hand-holding as other financial products, but annuitants may nonetheless worry about the impact of financial developments on the security of their future income stream. The need to provide staff to answer their questions increases the servicing costs of annuities. More important, the sales costs of individual annuities can be substantial. In addition to the impact of adverse selection, the gap between measured MWRs for the population as a whole and unity is probably largely attributable to the costs of individual sales. Mandatory annuitization would reduce adverse selection and the costs associated with it, and some form of group annuitization would reduce both sales and administrative costs. Mandatory annuitization would also make widespread or universal group annuitization more feasible than it otherwise would be. These issues are taken up again below. In any case, the fact that MWRs are less than one does not imply that they are a bad investment, since the MWR is not a reliable indicator of the insurance value of annuities (Brown 2001; Mitchell, Poterba, and Warshawsky 1999). The MWR calculation takes no account of an annuitant s fear of poverty in old age. Thus, an American male aged 65, who has about a 50 percent chance of living to age 80, is assumed to discount income in his 80s by more than 50 percent, and will attach very little weight to consumption in his 90s. Anyone who is truly averse to the prospects of growing old in poverty or being a burden on his family will place a higher 11

13 12 weight on the annuity s guarantee of lifetime income. Someone with a total aversion to the risk of outliving his resources would act as if he were assured of living to some very ripe old age (say 90 or 95), and would value a life annuity highly. 16 Annuity Providers Insurance Companies and the Risks They Face Only life insurance companies may underwrite life annuities in the United States, although other financial institutions may sell them. There are many web sites with information on annuity premium quotes, and it is quite easy to buy a life annuity over the Web. Apart from the legal monopoly of annuity underwriting that life insurance companies enjoy, they have some comparative advantage in this activity because of the economies of scope obtainable by providing both life annuities and life insurance. The provision of both of these products requires the knowledgeable estimation of life expectancies and survival probabilities, and hence the services of actuaries. In addition, life annuities and life insurance are natural hedges for one another. 17 A further and important rationale for joint provision is that the premiums for each type of insurance are invested in similar ways, with an emphasis on fixed interest instruments. This emphasis stems from the nature of the commitment that the insurance company enters into when it sells a fixed life annuity the payments on an annuity are exactly like those on bonds as long as the annuitant survives in that nonpayment constitutes default. The obligation that an annuity 16 Given current life expectancies in the United States, and assuming a MWR of.90 and an interest rate of 6 percent, a 65-year-old male could acquire a monthly income for life worth $2,000 for a premium of about $257,000. Assuming a maximum life span of 100 years, he would require wealth of about $350,000 to generate an equivalent income stream. With a maximum life span of 90 years, he would require wealth of $307,000. The possibility of annuitization is therefore worth close to $100,000 to the highly risk averse person in the first case, and about $50,000 in the second. 17 The life insurance company loses money if annuitants live on average longer than expected, but gains when life insurance policy holders live longer than expected. However, Atkinson and Dallas (2000, p. 682), referring to the U.S. market, note that required capital formulas do not allow mortality and longevity risk to be offset against each other. 12

14 13 contract entails places a limit on the share of the portfolio of assets funding the annuities that could be invested in equities or high-yield bonds. There may be some scope for investing a part of the portfolio in these higher-risk instruments, however, if doing so increases the mean return without increasing risk appreciably. The insurance company confronts a number of risks in providing annuities, notably interest rate risk and investment risk if it invests in equities and mortality or survival risk. Interest rate risk is the risk that the company s income from its fixed interest investment falls short of projections. The company can minimize its exposure to interest rate risk by immunizing its portfolio, that is, by matching its expected payments stream with the interest and redemption schedule of its portfolio of bonds and other assets. How successful the policy of immunization can be will depend on how complete the bond market is, and on its length. Suppose for the sake of example that an annuitant s maximum life postretirement is 30 years, and ignore other risks for the moment. Since the maturity of Treasury securities ranges from 30 days to 30 years, with no gaps in between, an insurance company could acquire a portfolio of bonds that would be perfectly matched with its liabilities to annuitants (leaving aside for the moment the uncertainty of annuitants life spans). 18 The life insurance company is assumed to be able to predict the proportion of its annuitants who will survive for n years (with n ranging from 1 to 30) after annuitization. It acquires a portfolio of bonds, and finances its annuity payments each year from the interest it earns on its portfolio and redemptions. With bond maturities through 30 years and only interest rate uncertainty to contend with, it can acquire a portfolio of bonds such that in any given year it need not sell any bonds that are not maturing in that year. It is thereby able to avoid the consequences of a falling bond market. In practice, a 30-year bond is not quite enough, since many Americans will still be alive more than 30 years after they retire and buy a life annuity. Consequently, some interest rate uncertainty is unavoidable. 18 In October 2001, the Treasury announced that it would discontinue sales of 30-year Treasury securities. This decision may increase the degree of interest uncertainty that insurance companies and pension funds have to cope with. 13

15 14 There will also be a trade-off between the average rate of return on bonds and interest uncertainty, since the insurance company that holds only government securities will earn a lower rate of return on average than one that invests in corporate securities, which have a higher yield. Some corporate and utilities debt is long-term, but most of it is issued at maturities of no more than 15 years. Since life insurance companies do invest in corporate bonds (typically, but not always, AA rated), they are exposed to more interest rate risk than they would be if they invested only in public debt. In addition, the higher yield of corporate debt comes at the cost of higher default risk. The apparent risk of default for the highest-rated corporate grades is not significant, but undergoes a noticeable increase with high-yield (i.e., junk) bonds. Liquidity risk the risk that in periods of generalized liquidity preference bond markets may effectively freeze up is especially significant for high-yield bonds, but may also affect even more highlyrated paper at times. Some simple simulations suggest that the impact of interest rate uncertainty in isolation with a bond market with maturities of up to 30 years is comparatively minor, since the share of the present discounted value of the expected stream of payments to annuitants who retire at the age of 65 and survive more than 30 years of retirement will not be large. Interest uncertainty becomes more important with higher-yield, shorter-maturity corporate bonds. Interest uncertainty can also combine with the other risks an insurance company faces to inflict substantial losses. When the yield curve slopes upwards, the insurance company can choose not to match the maturity of its assets with its liabilities, and keep a substantial share of its bond portfolio in longer maturities in the expectation that the resulting gain in interest income may offset the capital loss when the longer-term debt is liquidated before its term. This strategy exposes the insurance company to capital loss, however, if the general level of interest rates increases by more than the 14

16 15 company expected it to increase. 19 Conversely, if maturities are not sufficiently long when annuity contracts are signed, an insurance company can suffer considerable losses by overestimating the level of future interest rates, a fate which recently befell one of the UK s oldest life insurance companies. 20 The inclusion of equities or other risky assets in the portfolio of assets increases the risk of capital loss, since maturity-matching is not possible. On the other hand, investing in equities can be justified if holding them for a long period reduces the risk of low returns to acceptable levels. As an example, it may be prudent to assume that the annuity payments made to those relatively few members of a group of retirees who reach the age of 85 or older could be financed from a specified share, invested in equities of the premiums the group paid when it retired at age The insurance company also faces some uncertainty if the number of its annuitants is comparatively small, since the law of large numbers will not then apply. This should not affect the larger companies, although it might affect the market for annuities to the very old, since their numbers will have declined. It may also affect companies just entering the business, to the extent that it takes time for them to build up a large policyholder base. More important, however, is the fact that even the average life expectancies of a given age cohort are not predictable with certainty. Life insurance companies will thus need to make relatively conservative assumptions about survival probabilities, increasing the cost of annuities above 19 If the term structure of interest rates slopes upward and proves to be an accurate predictor of future interest rates, the company will incur losses on its sales of longer-term bonds, which it may or may not have predicted. 20 The company, Equitable Life, was obliged by its losses to stop accepting new business in December See House of Commons (2001) for an interim report from the Treasury Committee of the British House of Commons on the company s difficulties. 21 Bodie (1999) challenges the view that the riskiness of stocks declines with the holding period. He argues that although the probability of a loss of any size declines with the length of time stocks are held, the probability of a large loss increases. 15

17 16 what they otherwise would be. A conservative approach is undoubtedly prudent, since underestimating the probability of survival can prove to be an expensive mistake. 22 Summing up the foregoing, life insurance companies selling life annuity contracts incur a binding obligation to make a series of fixed payments at regular intervals whose number is not completely predictable. The risk to them of this commitment can be minimized by holding government debt with an appropriate balance of maturities. Some diversification of their portfolios to include equities and higher-yield bonds may increase the overall rate of return without increasing risk substantially, and allow life insurance companies to offer more competitively priced annuities. This strategy entails accepting both an increase in interest rate risk (because of the shorter maturities of corporate debt) and in default risk. It may be hard to gauge the point at which an increased share of higher risk instruments increases risk unacceptably. Given the fact that it takes some time to determine whether the sale of annuities to a given cohort of retirees has been profitable, the pressure of competition can induce life insurance companies to offer premiums that expose them to considerable loss if their interest rate assumptions prove to be wrong. 23 This issue takes on a special relevance if life annuities are protected by a public guarantee. Regulatory Aspects 22 Simulations with a simple model imply that underestimating the life expectancy of a 65-year-old American male by 1.3 years would increase the present discounted value of the expected income stream of an annuity by more than 8 cents on the dollar. 23 A life insurance company will not know whether its contracts with a given cohort of retirees are profitable or not until most of the cohort has died. This can create an incentive to offer annuities at very attractive rates in the hope that interest rates will increase, or at least not decline. The need to maintain reserves against future liabilities should discourage this practice if the interest rate used to calculate reserves is relatively low. 16

18 17 In the United States, the states are responsible for the regulation of the life insurance industry. 24 The federal government and its agencies play no direct role in its regulation. The Pension Benefit Guarantee Corporation, the federal agency responsible for overseeing pension plans, provides guarantees for the group annuities that pension plan administrators purchase for their plan members, but not for individual annuities. Similarly, the Department of Labor s safest available annuity standard, which is designed to protect private pension plan members, does not apply to individual annuities. The framework that governs life insurance investment policy combines two approaches or philosophies to regulation: the prudent person (or prudent portfolio ) framework, and the quantitative restrictions framework. Under the prudent person (PP) approach, the company s investment policy is supposed to be guided by the test of what a prudent person would do in the circumstances. The PP approach, like the legal concept of the reasonable man, is hard to pin down, since the standard it sets for persons in a fiduciary capacity is not always clear-cut. 25 The quantitative restrictions approach sets ceilings on the share of the portfolio that may be invested in particular asset classes. For example, in Delaware, 250 percent of capital and surplus may be invested in shares, 25 percent in real estate, etc. The National Association of Insurance Commissioners (NAIC), which is composed of the state insurance commissioners of the 50 states and 4 territories, exists to encourage state regulatory agencies to impose a regulatory framework of adequate rigor, and to that end has drafted model regulations governing such areas as transactions between life insurance companies and their 24 The McCarran-Ferguson Act of 1945 precludes the application of federal statutes to the life insurance business, unless they specifically relate to that business (GAO 1999). 25 An MBA graduate conversant with modern portfolio theory might consider it prudent to hold risky assets in a portfolio if he believed they reduced its overall variance. A more traditional fiduciary might be adverse to holding risky assets regardless of their impact on the portfolio. Del Guercio (1996) finds that the stock portfolios of bank fiduciaries are by comparison with mutual funds tilted toward high-quality stocks. This she attributes to the banks greater exposure to liability and the courts interpretation of the prudent man rule, which emphasizes the qualities of individual stocks, and not their contribution to efficient portfolio diversification. She infers that if a similar pattern is evident for investments in other assets, diversification across asset classes may be inefficient. 17

19 18 holding companies and affiliates. Nonetheless, the quality of regulation and supervision is thought to vary from one state to another. The experiences of several life insurance companies in the late 1980s and early 1990s pointed to problems with the regulation of the industry, leading to efforts by NAIC to improve quality in lagging states (General Accounting Office 1999). In the event that life insurance companies do get into financial difficulties, each state has a privately administered guarantee system that provides annuitants with some protection. The guarantee is financed by a levy on financially sound companies to assist the troubled company or companies in meeting its obligations to creditors and policyholders. This financial arrangement is neither funded nor administered by the state. An annuitant s claim on the life insurance company has no special status he is simply another creditor, and in fact his claim is subordinated to that of the bond holder. Moreover, the assets that fund annuities are not treated collectively like a pension fund s assets; that is, they do not constitute a separate entity that is distinct from the company s other assets, and they may be attached by the company s creditors. 26 As Perun (undated) notes, very few annuitants have taken a loss on fixed annuities. Nonetheless, it has happened. Holders of annuities from two fairly large life insurance companies received only 70 cents on the dollar when the companies got themselves into serious financial difficulties as a result of poor investments (GAO 1995). These investments were in one case hidden from the regulator by an excessively consolidated accounting presentation. The problem does not seem to have been excessively lax quantitative restrictions. The suitability of the current regulatory framework in the event the annuities business begins to boom as a result of an individual accounts reform is a question worthy of more than idle speculation (see Section V). 26 Perun (undated) notes that variable annuities are an exception to this. They are treated in the same way as mutual fund holdings. This difference reflects the fact that variable annuities are invested in the stock market, and only a minimum rate of return is guaranteed by the insurance company. 18

20 19 III. Mandatory Annuitization: Extent, Form, and Scope for Exemptions The Pros and Cons of Mandatory Annuitization Most people can benefit from the annuitization of some of their wealth in old age, particularly those individuals who would have problems managing their expenditure without the framework of control that annuitization provides. However, mandatory annuitization can mean excessive annuitization for some workers, such as those with a generous employer-provided pension. For them, a policy that required only partial or no annuitization of withdrawals from the IA (or for that matter, the conversion of the social security benefit into a lump-sum) could be welfareenhancing. For the dying, it could be a great blessing. Complete liberalization of restrictions on withdrawals from an IA suffers from a significant drawback, however. It may well leave many Americans with too little insurance against longevity and against inflation. It would be unwise to be complacent about the risk of overspending during retirement. The same arguments that justify compulsory participation in social security remain valid for restrictions on withdrawals from an IA. 27 In fact, as the life expectancies of older Americans increase, the arguments have even more validity. Many of the workers who will turn 65 in the coming years can expect to live for an additional 25 to 30 years. For the poorest fifth of the population approaching retirement, social security accounts for virtually all income in annuitized form. Given the decline in the value of the social security benefit that could occur over time in some reform scenarios, complete liberalization of withdrawals from individual accounts could entail a large decline not only in the share of annuitized wealth in total wealth, but also in the real value of annuitized income. A combination of bad luck (including unexpected inflationary shocks), unwise investment decisions, and reckless spending would then increase the risk of poverty for the bottom fifth of Americans in their old age. Given the hugely important role of social security for the elderly poor in the United States, they would be more 27 For a forthright statement of the need for compulsory saving, see the section Do We Really Need Mandatory Social Insurance? in the introduction to Aaron and Reischauer (2001). 19

21 20 vulnerable than the affluent to the potential risks of unrestricted withdrawals. This risk would be mitigated by subsidization of individual accounts advocated by some reform plans; for example, that of Representatives Kolbe and Stenholm (see Appendix 2). It is sometimes argued that the current practice of paying social security benefits in the form of life annuities hurts the poor, and poor African Americans in particular, because their life expectancies are shorter than the average, and that they would be better off with the lump-sum equivalent of their benefit upon retirement, instead of the social security annuity, since they could then bequeath it. 28 These arguments overlook the insurance value of the current arrangement. That the expected return may be less for an African American than for another American with the same earnings history does not ipso facto make the annuity a poor investment for her. In any case, the issue of the impact of race on the redistributive aspect of social security remains a subject of great debate. The findings of Cohen and Steuerle (2001) imply that the favorable redistributive impact of social security stemming from the lower average incomes of African Americans largely outweighs the impact of their shorter life expectancy. The risk that premature death poses for the holder of a simple life annuity contract can be hedged, as noted, by buying an annuity with a guaranteed income feature, or one with a death benefit. The premiums of both these annuities exceed that of a simple life annuity with the same regular payment. They have to cost more, because the insurance company is required to make payments after or upon the death of the annuitant that it would not have to make with a simple life annuity. Introducing this feature into the current system would only increase its cost. In any case, the benefits of the current system include an important joint survivor feature in the form of a pension for the spouse of the deceased worker (see Appendix 1). These alternatives to a single life annuity illustrate the inescapable trade-off between the maximum size of bequest that a retiree can make and the amount of longevity insurance the security and average level of retirement income she can obtain. 28 See Tanner (2001). 20

22 21 The Extent of Annuitization The preceding discussion suggests that the real issue is not whether annuitization should be mandatory, but what share of the funds in the individual account should be annuitized. Under current law, the indexed annuity provided by social security is designed to replace income at a decreasing rate up to a specified ceiling. Specifically, and taking the case of the worker who has been employed for 35 or more years since age 21, the social security benefit replaces 90 percent of the first $561 of average indexed monthly earnings (AIME) of the best 35 years (wages are indexed to the national wage index); 32 percent of the next $2,820; and 15 percent of the excess up to the specified ceiling. 29 The brackets, which are those that applied in 2001, are also indexed. One possible annuitization rule would be to maintain the replacement principle and the current replacement schedule, by requiring that the account holder annuitize enough of the accumulated funds in his account so that the sum of his social security benefit and the annuity payment would equal the benefit he would have received under current (pre-reform) law. 30 If benefits need to be reduced as part of the reform package, then the replacement schedule would have to be changed, and average replacement rates lowered. The new schedule could be interpreted as the schedule that would have prevailed under a conventional reform of social security in which individual accounts played no role. 29 Workers with less than 35 years of employment have their average monthly insurable earnings reduced proportionately. For example, with 30 years of employment, the AIME would be calculated by first indexing annual earnings for each year, summing, and dividing by 35 (see Appendix 1). 30 Note that if the public sector is providing the annuity, it could be combined with the social security benefit. If the private sector is providing the annuity, then it will be a separate payment underwritten by the insurance company that issues the annuity policy. 21

23 22 This raises the question of whether it is necessary to maintain the current extent of annuitization, and what principle to follow in determining its extent. Speaking rather broadly, an annuitization rule can be based on a replacement principle (as just described); a minimum income principle, or a combination of the two. Under a minimum income principle, the sum of the social security benefit and the annuity payment would be no less than a stipulated income level in dollars: for example, 75 or 100 percent of the poverty line. The poverty line that would apply in a particular worker s case would be the one calibrated for a family of the same size as the worker s family. The report of the President s Commission to Strengthen Social Security (2001) advocates a version of the minimum income principle. A mixed approach might combine a minimum determined by the poverty line and a replacement schedule that declined more steeply than the schedule implied by current law. This version of the mixed approach effectively assumes that compulsory annuitization is less important (at the margin) once a worker s income has reached a certain level. The Chilean individual accounts system applies a mixed approach to determine the share of the funds in an IA to be annuitized, although the replacement rate enjoyed by most contributors to the Chilean individual account system exceeds the American system s replacement rate. Very few Chileans now working will receive a pension from the state when they retire. Instead, their retirement will be funded by their IA, and they will choose between a series of programmed withdrawals and a life annuity. The life annuity offered by Chilean insurance companies must provide an income with a replacement ratio of at least 70 percent of average indexed earnings over the last 10 years of working life with a minimum equivalent to 120 percent of the minimum wage if the balance of the account is to be withdrawn in a lump sum. 31 If the replacement ratio falls short of 70 percent, then the entire account balance must be used to acquire a life annuity (which may be deferred) or to fund a series of programmed withdrawals. No account is taken 31 See the web site (in Spanish) of the Chilean Association of Pension Fund Managers ( or Rodríguez (1999). 22