1 Annuities in Pension Plans: Dr David Blake Director Pensions Institute, U.K. The World Bank, Annuities Workshop 7-8 June 1999
2 Purpose of Pension Plan To provide retirement income security for remaining life To eliminate the risk that the pensioner outlives his/her resources
3 Definition of life annuity Financial contract that provides regular income to purchaser for their remaining life
4 Types of Annuities Level annuity. Escalating annuity Index-linked annuity Limited price indexed (LPI) annuity With-profit and Unit-linked (or variable) annuity
5 Alternatives to Annuities Lump sum: accumulated fund goes to pensioner on retirement State provision: on pay-as-you-go basis
6 Alternatives to Annuities (2) Income drawdown (managed annuity or pension): Capital sum remains invested and individuals draw income from fund of between 35% and 100% of single-life level annuity
7 Alternatives to Annuities (3) Until age 75 when a standard annuity must be purchased On death (before annuity drawn), the balance of the fund as lump sum
8 Problems that must be dealt with Should pensioners be obliged to purchase annuities or should they have some other choice?
9 Effectiveness of Provision Thin market: only 10 of around 240 authorized life companies in the U.K are serious providers of life annuities. How efficient will be the provision of the alternatives to annuities?
10 Adverse Selection and Mortality Risk Only those who believe that they are likely to live longer than average voluntarily purchase annuities To hedge, the insurance company will base its annuity rates on the select group that is most likely to purchase annuities. Why?
11 Adverse Selection and Mortality Risk (2) Because difficult to differentiate between prospective purchasers who will experience heavier mortality (and so make a profit for the insurance company) and those who will experience lighter mortality (and hence make a loss for the insurance company).
12 Adverse Selection and Mortality Risk (3) Annuities poor value for money for members of the first group. Underestimating mortality improvements Mortality forecast errors of up to 20% over intervals as short as 10 years are not uncommon.
13 Adverse Selection and Mortality Risk (4) U.K. insurance companies underestimate average life expectancy of their pool of annuitants by up to two years Insurance companies add substantial cost loadings to cover these risks (12%)
14 Inflation Risk Unanticipated high inflation rapidly reduces the real value of the pension
15 Interest Rate Risk Annuity rates vary substantially over the interest rate cycle. Related to yields on government bonds of the same expected term which vary by up to 150% over the cycle.
16 Problems With Alternatives to Annuities Lump sum: Pensioner now bears mortality risk Moral hazard of spending lump sum too quickly and then going back to state for help. State provision: Demographic timebomb
17 Problems With Alternatives to Annuities (2) Income Drawdown: Annuity rates might actually be lower when annuity purchased Investment performance during deferral period might be poor so fund falls in value
18 Problems With Alternatives to Annuities (3) Income Drawdown: Individuals forego mortality crosssubsidy which is cumulative over time By delaying purchase of an annuity, individuals experience a so-called mortality drag
19 How Are the Problems With Annuities Currently Managed? Insurance companies use government bond market to protect against both interest rate and inflation risk arising after the annuity is purchased Annuitants themselves remain exposed to interest and inflation risk
20 How Are the Problems With Annuities Currently Managed? (2) If DC scheme member retires during an interest rate trough (as happened in the mid 1990s in the U.K., for example), he or she can end up with low pension
21 How Are the Problems With Annuities Currently Managed? (3) Similarly, if 65-year male chooses indexed annuity, he receives initial cash sum about 30% lower than level annuity With inflation at 3% p.a., it takes 11 years for the indexed annuity to exceed the level annuity
22 How Are the Problems With Annuities Currently Managed? (4) and 19 years before the total cash payments are equalized Most people take level annuity and retain the inflation risk
23 Outcome Insurance companies use financial markets to hedge interest and inflation risks that they face from purchase date Interest rate risk up until this date borne by future annuitant, and inflation risk after retirement date borne by level annuitant.
24 Outcome (2) Mortality risk and risk of underestimating improvements in mortality shared: insurance companies claim to lose money on annuity business.
25 Can Mandatory Annuities Help? Main causes of private market failure in annuity provision: adverse selection and mortality risk. Mandatory annuities would help remove adverse selection bias in demand for annuities.
26 Can Survivor Bonds Help? Survivor bonds: coupons linked to realized mortality Removes risk from underestimating mortality improvements Insurance company bears no aggregate mortality risk and cost loadings fall.
27 Can Mandated Providers Help? How many annuity providers? State As Monopoly Provider Small Group Of Competing Specially Licensed Providers
28 State As Monopoly Provider Advantages: Substantial economies of scale in provision of annuities lowers unit costs of providing annuities State bears large aggregate risks relating to mortality and mortality improvements that private insurance companies dislike bearing
29 State As Monopoly Provider (2) Advantages: State would, in effect, be issuing survivor bonds and the purchase of these would help to fund the national debt State could also assume interest rate risk by offering smoothed annuities, i.e., annuities that are smoothed across the interest rate cycle.
30 State As Monopoly Provider (3) Disadvantages: Few examples anywhere in the world of state organizations run on commercial lines that are efficient
31 Small Group Of Competing Specially Licensed Providers Advantages: Allows private sector to offer annuities and also permit each provider to gain sufficient market share to justify entry to the market Efficiency results from competition between the providers
32 Small Group Of Competing Specially Licensed Providers (2) Disadvantages: Danger of collusion Danger of wasteful rather than efficiency-enhancing competition: e.g., costly marketing campaigns to attract new customers.
33 Small Group Of Competing Solution: Specially Licensed Providers (3) Avoid collusion by artificial segmentation of market. Government helps these companies keep costs down with indexed and survivor bonds
34 Other Issues Should organizations selling annuities be restricted solely to sale of annuities or should they be permitted to sell other life assurance products as well? If the domestic annuity market is small and poorly developed, should foreign annuity providers enter the market?
35 Other Issues (2) But paucity of accurate mortality data in such countries? Should the annuity investments be held in domestic assets only or should international investments be permitted? What about the associated currency risk?
36 Conclusion Simple answer to: is there an alternative to annuities? No Real issues: what type of annuities and who provides them?
37 Conclusion (2) Four tier structure to pension provision Indexed linked annuity tier Level annuity tier Variable annuity tier Lump sum or drawdown
38 Conclusion (3) Inevitable Role for the State: Annuities cannot exist without the state being either a monopoly provider or providing financial instruments that enable the private sector to purchase matching assets against their liabilities
39 Conclusion (4) Inevitable Role for the State: State must establish institutional framework for the pension annuity business that offers the appropriate incentives for annuity providers to compete effectively and economically
40 Conclusion (5) Inevitable Role for the State: Requires mandatory pension annuities, since this would help to reduce costs associated with both adverse selection and the marketing of voluntary arrangements
41 Conclusion (6) Annuities a shared responsibility between public and private sectors: Greater reliability of mortality data Greater inventiveness by financial system
42 Conclusion (7) In small, developing countries with inadequate mortality data and unsophisticated financial system, state may have to provide annuities directly or it has to kick-start private annuity market with indexed and survivor bonds