Explaining the Demand for Life Annuities in the Australian Market. Amandha Ganegoda

Transcription

1 Explaining the Demand for Life Annuities in the Australian Market Amandha Ganegoda CPS Discussion Paper 05/2007

2 DRAFT Comments welcome Explaining the demand for life annuities in the Australian market Amandha Ganegoda* October 2007 Abstract: Recent reforms to the taxation and age pension means tests have shifted the demand for income streams away from annuities to allocated products (now called account-based pensions). However, annuities and particularly life annuities have unique insurance features. This raises questions about the demand for life annuities and the value of life annuities to retirees. This paper reports new money s worth results for six different classes of annuities and presents evidence indicating that while the loading on Australian life annuities has almost doubled over the last five years, the cost of adverse selection as a percentage of the total loading has fallen. Further, estimates of the insurance value of Australian life annuities, using a utility-based measure of a life-cycle consumer s valuation of annuities, indicate that retirees would accept a reduction in their wealth that is greater than the prevailing loading in order to receive protection against longevity risk. We draw the conclusion that the loading alone cannot explain the prevailing thin annuity market in Australia. * I wish to thank Associate Professor Hazel Bateman at the School of Economics, University of New South Wales for her supervision and guidance. I also like to thank Professor Jeffrey Brown at the College of Business, University of Illinois for generously supplying the dynamic programming code for insurance value calculation. The code has been altered to fit the Australian experience and responsibility for any programming error is confined to the author. 1

3 1. Introduction A large amount has been written about the lack of demand for annuities experienced around the world, and economists have put forward many reasons to explain this so called Annuity Puzzle. One explanation is that annuities are too costly due to loadings. The primary purpose of this paper is to provide an update of estimates of the loadings for Australian annuities and then to investigate the impact of these loadings on the demand for annuities. Historically in most of the OECD countries it has been governments responsibility to finance the retirement of their elderly citizens. With the global phenomenon of population ageing there have been serious concerns as to whether state-funded defined benefit (DB) pension schemes are still viable. Many governments have initiated reforms to replace or supplement the traditional state-funded DB plans with private defined contribution (DC) plans. Unlike traditional DB plans, which are paid out in a form of life annuity, DC plans have no set method to drawdown the savings. In the absence of such a mechanism, retirees are exposed to a variety of risks in retirement. These include: replacement rate risk - the risk of not adequately replacing pre-retirement income; investment risk - the risk of unevenness in income/consumption due to volatility of investment returns; longevity risk - the risk of outliving financial resources; inflation risk - the risk of erosion of purchasing power; and contingency risk - the risk associated with uninsurable events. One method that has been put forward to properly manage the drawdown of retirement provision is to purchase an annuity (Yaari 1965, Davidoff et al 2005). The Australian annuity market provides a wide range of products that are designed to transfer or at least mitigate most of the financial risks faced by individuals during their retirement. However, despite their appealing features, the Australian annuity market remains thin. Very few Australians annuitize their superannuation savings. Recent data from APRA reports that in , only 38 per cent of retirees took their superannuation savings as pensions 1. And of those who take out their superannuation as lump sum, very few would use that to purchase annuities. Using Australian Treasury data, Doyle, Mitchell and Piggott (2004) reported that only 3 per cent of the estimated 100,000 Australians retiring each year purchased life annuities. 1 June 2006 Statistical Bulletin. 2

4 Australia is not the only country experiencing a lack of annuitization. Similar experiences have been reported around the world. For example Friedman and Sjogren (1980), reported that only 2 per cent of elderly in US own individual annuities of any sort. And, although there has been a rapid growth in the US annuity market since 1990, the volume of annuities sold in US still remains thin (Brown, Mitchell, Poterba and Warshawsky from now on referred to as BMPW). A similar experience has been reported in the UK voluntary annuity market by Finkelstein and Poterba (1999). They report that annual annuity payments to annuitants in the compulsory annuity market in UK in 1996 were 3.9 billion, while this figure in voluntary market was only 0.8 billion. Similarly, thin annuity markets have been reported by many other countries including Switzerland, Israel and Canada (James and Song 1999, James and Vittas 1999). In contrast, there has been a significant boost in the size of the annuity market in Singapore with the introduction of government s minimum sum scheme 2. Provided the market for annuities is actuarially fair, the standard life-cycle model of consumption and saving behavior suggests that an individual with no bequest motive would choose to annuitize all their wealth. Thus the fact that only few retirees buy annuities has long been a puzzle to many economists. Many reasons have been put forward to explain this Annuity Puzzle. These include: 1) Strong bequest motives of retirees. Bernheim (1991) concludes that many people would stop short of converting all their assets into annuities, even in the presence of perfect insurance markets due to their bequest motive. 2) Precautionary savings in order to finance contingent events such medical expenses (Brown 2001, Mitchell and Turra 2004) 3) Intra-family risk sharing as a substitute for annuities (Brown 2001, Kotlikoff and Spivak 1981). 4) A significant proportion of wealth is already annuitized due to social security or employee defined benefit plans. For example, using data from the US Health and Retirement (HRS) Study, Moore and Mitchell (1998) report that, US households with median wealth levels held 40 per cent of their wealth as annuitized social security 2 In 1987 the Singapore government established the Minimum Sum Scheme. This scheme specifies that upon retirement workers can only withdraw their savings from Central Provident Fund after setting aside a minimum sum specified by the government to a) buy a deferred life annuity payable at age 62 or b) a deposit with a bank or c) leave with the Central Provident Fund and take out in gradual withdrawals. 3

5 entitlements. Even the wealthy households maintained roughly around 15% of their wealth in the form of annuitized social security. 5) Annuities are too expensive due to loadings from administration costs and selection costs (Warshawsky1988, Friedman and Warshawsky1990) The focus here is on loading costs and adverse selection in Australian annuities market and the discussion is limited to the impact of loadings on annuity demand. A detailed discussion of other factors affecting annuitization can be found in Warshawsky (1988), Friedman and Warshawsky (1990), Milevsky (1988) and Brown (2001). Loadings and Selection Costs Annuity prices are almost never actuarially fair. This disparity between the market price and the price if the annuity was actuarially fair is called the loading. In other words it is the difference between the purchase price of the annuity and the expected present discounted value (EPDV) of annuity payments. Using data for 2000, Doyle, Mitchell, and Piggott (2004) report that loadings for annuities in Australia are around 10 per cent. Similar findings have been reported by Finkelstein and Poterba (2002) and Brown, Mitchell and Poterba (1999) for UK and US annuities respectively. (See Appendix A) There are many reasons why such a disparity occurs including administration costs, selection costs, operating costs, profit margins etc 3. Among these, adverse selection seems to be the most significant factor. A study by Doyle, Mitchell, and Piggott (2004) on Australian annuities based on 2000 data reports that roughly 50 per cent of the loading for a male in the Australian annuity market is due to adverse selection. For a female this figure was around 36 per cent. For the US, Brown, Mitchell and Poterba (1999) report that adverse selection accounts for roughly 85 per cent of the loading for males and 70 per cent of the loading for females. In the UK, adverse selection as a percentage of the loading has been estimated at 90 per cent of the loading for males and 60 per cent for females (Finkelstein and Poterba 2002). Similar findings have been reported in Canada and Switzerland by James and Vittas (1999). (see Appendix A for more details) 3 See Purcal (2006) for detail discussion on why annuity providers fail to provide actuarially fair annuities. 4

6 Finkelstein and Poterba (1999) suggest that adverse selection can be caused by active selection or passive selection. Active selection occurs when individuals use private information about their health status on the decision to annuitize. A study by Hurd and McGarry (1995) using HRS data from US has presented evidence that individuals have a reasonable ability to forecast their lifespan. Thus an individual who believes they will live longer will be more likely to buy an annuity, whereas someone who doesn t believe so will not. In contrast, passive selection happens when the individuals who choose to buy annuities have other attributes that could lead to a longer lifespan. For example, Attanasio and Hoynes (1995) present evidence that those wealthy individuals with a high socio-economic background who are more likely to buy annuities, show significantly higher rates of longevity than the general population. An important feature of life annuities is the provision of longevity insurance. It is therefore appropriate to assess this so-called insurance value of life annuities against the costs (or loadings) associated with the provision of life annuities. The insurance value estimates the amount of wealth consumers would be willing to forgo in order to receive protection against longevity risk. If the insurance value of annuities is less than the loading then consumers may consider annuities to be too expensive and may not purchase annuities. Brown (2001) shows that the insurance value of annuities is positively correlated with the decision to annuitize. BMPW (1999) report that 65 year olds in US would be willing to forgo around 30 to 40 per cent of their wealth in order to receive protection against longevity risk. However the authors state that the amount of wealth individuals are willing to forgo may reduce with the presence of social security, stochastic inflation, bequest motives and self insurance through family structure. In another study Mitchell and Turra (2004) provide evidence that retirees in poor health who expect to pay large out-of-pocket medical bills, value annuities much less than those in good health. This paper provides an update on the Australian annuities market and the money s worth ratios and undertakes the first estimates of the insurance value of Australian annuities. The paper is set out as follows. The next section provides an overview of the annuity market in Australia, including the different types of annuities available and their market share, the treatment of annuities under the age pension means tests, and the tax treatment of annuities. In section three the loadings on annuities in Australia are estimated by calculating the money s worth ratio (MWR). This requires estimation of survival probabilities for the general 5

7 and annuitant population, an estimation of the term structure of interest rates and current quotes for life annuities. Findings suggest that the loading on a nominal life annuity for a 65 year old male in the general population is around 24 per cent, which is more than double the previous estimates for Australian annuities reported in Doyle, Mitchell, and Piggott (2004) using data for The results also suggest that the loadings on Australian annuities are significantly higher than international experience, but that adverse selection as a percentage of the loading is significantly lower. Next, in section four, the insurance value of annuities using a utility-based measure of a life-cycle consumer s valuation of annuities, is estimated. The question is asked - how much wealth retirees would be willing to forgo in order to receive protection against longevity risk? Results suggest that the average 65 year old male would accept a reduction of between 31 per cent and 55 per cent in order to protect themselves against longevity risk. These insurance value estimates are significantly higher than the estimated loadings, which suggest that loadings alone only cannot explain the prevailing thin annuity market in Australia. The final section concludes with a discussion on possible areas of future research. 2. Overview of the Australian Annuity Market Since the implementation of Simplified Superannuation in 2006 and 2007, the retirement income streams available in Australia can be broadly categorized as: Allocated products (also known as account-based pensions); and Immediate annuities Allocated products include allocated pensions/annuities 4, and term allocated pensions (TAPs) and account-based pensions, while immediate annuities include term and life annuities. A summary of the Australian income streams market as at September 2006 indicates that the allocated pensions/annuities are the most popular type of retirement income streams, accounting for 87.6 per cent of the market share. In contrast immediate annuities only represent 9.83 per cent of the total market. (see Figure. 1) 4 Allocated annuities and allocated pensions are essentially the same products except there are some structural and legal differences which arise due to the fact that allocated pensions are payable by a superannuation fund or retirement savings account provider while allocated annuities are payable by a life insurance company. 6

8 Figure 1: Market Share Based on Sales as at September 2006 Total Allocated Pensions & Annuites 87.60% TAP 2.58% Total Term (w ithout RCV) 2.94% Total Term (With RCV) 6.73% Immediate annuities Total Life 0.16% Source: based on calculation carried out using IFSA Retirement Income Streams Report for the period ended 30 September Immediate Annuities An immediate annuity is an insurance contract which provides predetermined income payments for life or a specified period of time, contingent upon death, in exchange for a lump sum investment. All immediate annuities sold in Australia can be broadly categorized into term certain annuities and life annuities. Life annuities provide a regular income for remainder of life, while term certain annuities are payable for a set period of time, e.g. 5, 10 years etc. contingent upon death. A particular type of term annuity is a life expectancy annuity which has a term equal to life expectancy of the annuitant. Both life annuities and term certain annuities could be designed to meet the pre July 2007 standards for complying income streams for social security and RBL (Reasonable Benefit Level) purposes. Over the years Australians have favored term certain annuities over life annuities. In 2006 term certain annuities accounted for over 98 per cent of the total immediate annuity sales, with the remainder being the life annuities. Life annuities are the least popular type of retirement income stream in Australia only accounting for 0.16 per cent of the total retirement income streams market share. (See Fig. 1). Apart from the life/term distinction, immediate annuities carry many distinct features which could be tailored to individual needs. These include: 7

9 Ownership: Immediate annuities can be bought by a single investor or if using non-etp monies by joint investors (usually a spouse). Minimum Guarantee Period: A minimum guarantee provides insurance against loss of capital due to premature death. If the primary annuitant dies within the guarantee period, income will continue to be paid to a nominated beneficiary or the estate until the end of the guarantee period. Escalation: Escalation provides protection against inflation. It can be a flat rate (usually up to 5 per cent) or indexed to annual inflation. Residual Capital Value: Term certain annuities have the option of keeping all or portion of the capital intact and having it returned at the end of the term. This is known as the Residual Capital Value (RCV). Term annuities with RCV are the most popular type of immediate annuities sold in Australia with a market share of 6.7 per cent of total income streams (See Fig 1) and 68.5 per cent of immediate annuity sales. However the market share of term annuities with RCV has consistently dropped over the years (see Fig. B.4 Appendix B). A possible explanation for this is that annuities with RCV do not (and previously did not) satisfy the standards for a complying annuity. (see Appendix C for more details on complying income streams) 2.2 Allocated Products (and account-based pensions) Prior to the implementation of Simplified Superannuation there were two types of allocated products sold in Australia - allocated annuities/pensions and term allocated pensions (TAPs). Post Simplified Superannuation, the generic name for this type of product is an account-based pension. The main difference between allocated products (account-based pensions) and immediate annuities is that in the former, the investor bears the investment risk Allocated Annuities/ Pensions Allocated annuities and allocated pensions have been the most popular type of retirement income stream product in Australia with a market share in 2006 of 87.6 per cent (see Fig. 1). Allocated pensions/annuities (and the new account-based pensions) allow retirees to invest their ETP in an investment portfolio according to their risk preference. The investment risk is borne by the retiree and the income will vary over time depending on the investment performance of the underlying assets. The term of the product is not fixed and payments cease when the account is depleted. There is no pooling of longevity risk so the retiree can run out of money before their death. 8

10 With the previous allocated pensions/annuities investors could decide how much income they wanted to receive annually, within statutory limits. The limits ensured capital was drawn down over time until at least age 80 years. Each financial year, limits were recalculated taking account of the investment return. Under the new rules, the annual income is subject to minimum drawdown regulations. The previous allocated pensions/annuities were commutable. Thus if the investor needed to draw down more than the allowed limit, they could withdraw a lump sum from the amount invested. Under the new account-based pensions there is no maximum drawdown limit. Having access to lump sum withdrawal is an attractive feature for most retirees, as they can protect themselves against contingency risk. Despite of the lack of protection against longevity risk, allocated (and account-based) products offer retirees considerable flexibility in managing their income. Another feature of allocated products (and account-based pensions which follow the minimum drawdown pattern) is that earnings on the underlying assets are tax free, in contrast to investment earnings on superannuation funds which are taxable at a 15 per cent rate. Thus allocated products provide a tax efficient flexible retirement investment option to retirees. This possibly explains the immense popularity of the previous allocated products, despite their less favorable asset test treatment (at least until September 2007) (to be discussed later) Term Allocated Pensions Term allocated pensions (TAPs), also known as market-linked income streams, were introduced in September A TAP is an account based product which meets the standards for a complying income stream. (see Appendix C). Term allocated pensions can only be purchased from superannuation or ETP monies and ownership of the product is with the ETP recipient. TAPs have similar account structure to allocated pensions/annuities. The main differences between TAPs and allocated pensions/annuities are that investor needs to surrender the capital (that is, they are non-commutable) and the investor has to choose a contract term that would satisfy the minimum standard for complying income streams. TAPs provide variable income depending on the investment performance of the underlying assets. The investor is required to draw a proportion of the account balance each year within the statutory limits, so that the account is exhausted at the end of the product term. 9

11 $115 mill in sales of TAPs were recorded in the 3 rd quarter of This represented a market share of 2.9 per cent of total retirement income streams. Despite being a complying income stream, TAPs still remain unpopular among retirees, possibly due to its noncommutability. Figure. 2: Market Share for All Income Streams from 1999 to % 90% 80% Allocated Annuities/Pensions Life TAP Term 70% 60% 50% 40% 30% 20% 10% 0% 1999 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q2 Source: based on calculation carried out using IFSA Retirement Income Streams Reports" 1999 to Age Pension means tests and retirement income streams Australia has a publicly funded, means tested, Age Pension for people who cannot fully support themselves in retirement. For most retirees the Age Pension provides a significant part of their retirement income. Bateman (2005) reports that, in 2003 around 73 per cent of the retired of eligible aged received some Age Pension of which 67 per cent received full rate. As well the Age Pension was the principle source of income for 70 per cent of elderly households. Thus, the means test treatment of income streams may have an impact on annuity demand as the decision to annuitize could affect the amount of Age Pension once could receive. 10

12 2.3.1 Means Testing Under the Age Pension means test arrangements, private income and assets are tested against separate assets and income tests to determine the amount of eligible Age Pension under each test and the test resulting in the lower rate of Age Pension is applied. (see Appendix D for more details on means testing) Assets Test: Since 20 th September 2007 the assets test reduces age pension by $1.50 per fortnight for every $1,000 of assets (including the outstanding capital value of all retirement income streams) above a statutory threshold 5. Under the pre Simplified Superannuation arrangements - complying income streams bought before 20 th September 2004 are exempt from the assets test, and if bought after 20 th September 2004 (but before 20 th September 2007) qualify for a 50 per cent asset test exemption. Income Test: reduces age pension by $0.40 per fortnight for singles and 20 cents per fortnight for couples for each dollar of income above the defined threshold. All income streams are tested under the income test Age Pension Means Tests and Annuity Demand Over the past few decades there have been many changes to the Age Pension means tests treatment and to the taxation and regulation of incomes streams. The rule changes appear to have had a significant impact on the demand for different types of income streams. For example, on 25 February 2004, the Australian Government announced changes to the Age Pension means test rules to take effect form 20 th September of that year. The key changes were a reduction in the assets test exemption from 100 per cent to 50 per cent for complying income streams purchased after 20 th September 2004 and a revision to the minimum standards for complying income streams (see Appendix C). These changes had a significant impact on the demand for annuities, as outlined below. Impact on Immediate Annuity Sales Prior to the Age Pension reforms in 2004, immediate annuity sales averaged around A$736 million per quarter and maintained a market share of averaging 31 per cent of total retirement income streams. After tightening the requirements for complying income streams in 2004, 5 Different thresholds apply depending on the family status and homeownership. 11

13 immediate annuities became less attractive for buyers. Sales dropped down to an average of A$389 mill per quarter and the market share dropped to an average of 20 per cent. This drop was significant in both life and term annuity markets. (see Fig. B1, B2, B3, B4 in Appendix B). The average quarterly sales of life annuities dropped by 78 per cent while sales of term annuities dropped by 45 per cent. Prior to reforms in 2004 there was an upward movement in sales of term annuities without RCV. Since the 2004 reforms, however, term annuities without RCV suffered significantly and sales have been constantly dropping (see Fig. B3, B4 in Appendix B). A possible explanation for this would be the changes to the minimum standard of a term for a complying income stream. Before the reforms, a 15 year term annuity was considered a complying income stream for an annuitant with a life expectancy equal or greater than 15 years, provided that the annuity satisfied other requirements of a complying income stream. (see Appendix C) After the reforms, however, the term of a life expectancy income stream was revised to align with the term of TAP. That is, the term was required to be between the annuitant s life expectancy and their life expectancy if they were five years younger. Due to this change many retirees were required to buy term annuities with a much longer contract length 6 than 15 years in order to qualify as a complying income stream. It is likely that this reduced the demand for term annuities without RCV since most retirees are reluctant to purchase longer term contracts. Another impact of the 2004 reforms was the changes in the sales structure of immediate annuities based on the length of contracts. Historical figures indicate that sales of short term and medium term annuities have fallen over the years both in relative and absolute terms. In particular, sales of 15 year term annuities dropped by 10 per cent between 1999 and This is possibly due to the fact that these annuities no longer satisfied the minimum standard of complying annuities for most retirees 5. Also, figures indicate that sales of long term contracts (especially 20 years and over) have increased in relative terms. (See Table 1) The increase in sales of longer term annuities is probably due to retirees buying such annuities in order to satisfy the new standards for complying income streams. 6 Prior 2004 reforms, 15 year term annuity without RCV was considered a complying annuity for a 55 year old male or female. After the reforms, minimum term required for complying annuity if purchased by a 55 year old male increased to 24 years and if purchased by a 55 year old female to 29 years. (based on Life expectancy tables) 12

14 Table 1: Percentage of Term Annuities (without RCV) Sales Split By Length of Term Length of Term 1 to 5 6 to to to Q2 to 2004 Q2 9.6% 14.7% 25.3% 36.9% 9.2% 4.3% 2004 Q4 to 2006 Q3 7.4% 19.9% 24.9% 26.4% 10.4% 11.0% Impact on Allocated Products The 2004 reforms had a positive impact on the sales of allocated products. Between 2004 and 2006, average sales have increased by 85 per cent for allocated pensions/annuities. (see Fig B5 in Appendix B) This increase is possibly due to customers switching from, the now less attractive immediate annuity products. 2.4 The tax treatment of retirement income streams Under the pre July 2007 tax rules, payments from retirement income products were assessable under the personal income tax and were taxed at marginal rates after allowing for tax offsets and deductibles 7. Allowable deductions and offsets included: an annual deductible amount which allows for capital repayment, the 15 per cent superannuation and annuity tax offset, the dependent spouse offset, and the senior Australian tax offset. See Appendix E for more details on deductibles. Since July 2007, superannuation benefits paid from a taxed fund, either as a lump sum or income stream are tax free when paid for individuals aged 60 years or over 8. Through these reforms government is expecting to provide incentives for workers to postpone their retirement and save more towards their retirement. It follows that the overall impact of the tax and Age Pension means test changes to retirement benefits has been to eliminate any incentives to purchase lifetime annuities. 7 If ETP monies are used to purchase the income stream, then there could be other tax liabilities including: 15% tax payable at time of purchase for untaxed post-june 1983 component of ETP and tax on lump sum received on commutation or RCV, which will be taxed under the superannuation benefit rules reforms made most of the components of ETP tax free. For pensions commenced on or after 1 July 2007, undedicated purchase price (See Appendix E) will include all the new exempt component of the ETP, which would consist of former Pre-July 1983, concessional, undeducted contributions, Post-June 1994 invalidity, and Capital gains tax exempt component. Thus higher deductible amounts may apply to these pensions effectively reducing the tax liability. For pensions that commenced prior to 1 July 2007, current arrangements for calculating the deductible amount remain. 13

15 3. The Money s Worth of Australian Annuities an Update This section provides an update of the money s worth estimates for Australian annuities and compares them with previous Australian and international estimates. Six classes of annuity products for both single and joint annuitants are considered. Estimation of the money s worth of annuities requires current annuity quotes, estimates (and projections) of the term structure of interest rates, and estimates (and projections) of survival probabilities for both the general and annuitant populations. The methodology employed to estimate the money s worth of Australian annuities is discussed below. 3.1 The Money s Worth Framework The framework used to compute the money s worth of Australian annuities and thereby quantify the cost of adverse selection draws on BMPW (1999). The basic approach is to estimate the money s worth ratio as the expected present discounted value (EPDV) of an immediate annuity as a proportion of the purchase price of an annuity, as follows: EPDV(annuity) Money's worth Ratio = (4.1) Purchase price The money s worth ratio tells us the present value of returns one could expect per $1 of annuity premium. In other words, a life annuity with a MWR of 0.95 implies that the annuitant is expected to receive 95 per cent of the present value of his investment during his life time. The 5 per cent of the present value he does not receive can be viewed as the cost of longevity insurance. This is called the loading. The standard formulas used to calculate the EPDV for a nominal single life annuity paying monthly income is: ( ω x) 12 A p EPDV(Nominal) = (4.2) t= 1 nom t /12 x t /12 (1 + it ) This formula can be modified to calculate the EPDV for single life annuities with different features, as follows: A A p EPDV(Nominal k yr guarantee) = + (4.3) t= 1 real t /12 x t /12 (1 + rt ) 12k ( ω x) 12 nom nom t /12 x t/12 t/12 t= 1 (1 + it) t= 12k+ 1 (1 + it) ( ω x) 12 A p EPDV(real) = (4.4) 14

16 p EPDV( j% annual esc) = A (1 + j) (4.5) ω x 1 12 k k+ t/12 x nom k+ t/12 k= 0 t= 1 (1 + it ) Where: Anom denotes the monthly nominal payout for a nominal annuity and A real denotes the monthly real payouts from real annuities, ω is the maximum age a person is expected to live (assumed to be 110), t/12 p x is the probability of survival until age t 12 + x by an individual who is currently aged x, i t denotes the annual nominal interest rate for maturity of t months and r t denotes the annual real interest rate for maturity of t months. Similarly, the EPDV of last survivor nominal annuities can be calculated using (4.6) t= 1 ( 1 ) ( 1 ) m f m f f m ( ω x) 12 Anom t/12 px t/12 py + θ A nom t/12 px t/12 py + t/12 px t/12 p y EPDV(Last Survivor) = (4.6) t /12 (1 + i ) t m Where, t/12 p x is the probability of survival for a male of age x until age t/12+ x and t/12 p has similar definition for females and θ is the percentage of annuity income payable f x for the survivor. All other symbols are same as for equation (4.2). Equation (4.6) can be changed analogous to (4.3), (4.4) and (4.5) in order to calculate the EPDV of last survivor annuities with a guarantee period and escalation. Therefore, in order estimate the EPDV (and the money s worth) of Australian annuities, one requires realistic annuity quotes, an estimate of the term structure of interest rates and survival probabilities. Annuity quotes The basis of the annuity quotes used in the money s worth estimates are the actual annuity quotes provided by the four life annuity providers in Australia 9 for a $100,000 purchase price in 2006 fourth quarter. These quotes are reported in appendix F. 9 Currently there are four life offices providing regular quotes on life annuities. They are AMP, AXA, CommInsure and MLC. This is down from 11 companies in (Doyle, 2006). The annuity quotes we use are reported in the DEXX&R publication, Retirement Income League Tables - Quarterly Statistics, December

17 It is observed that there is considerable variation in annuity payouts among the four annuity providers. Similar observations have been made for the UK by Friedman and Warshawsky (1988) and for the US by BMPW (1999). One explanation for this dispersion is the difference in mortality and interest rate assumptions used by companies to price their annuities. Another explanation would be lack of readily available annuity quotes. Lack of pricing information makes it difficult for customers to compare prices, which leads to less competition and price dispersion among companies. James and Vittas (1999) undertake an international comparison of annuity payouts and point out that price dispersion is least in countries where on-line price information is available. To address the variation of annuity payouts for the purpose of this study, the annual payouts were converted to monthly payouts and then the average payouts were used in the EPDV calculations for each type of annuity. Appendix F reports the average payout for each type of annuity. Interest rates The term structure of interest rates was derived using Australian Commonwealth Treasury Bonds and Bank Bills - specifically the end-december 2006, 30-day, 90-day, 180-day bank bills and 1, 2, 3, 4, 5, 6, 8, 10 and 12 year treasury bond yields. The term structure was estimated using the method of polynomial splines. The spline method is a non-parametric regression method that can be employed when we do not wish to use a specific model to fit a curve. It is assumed that the term structure of interest rates can be estimated using the piecewise quadratic function given by equation (4.7): 2 a0 + at 1 + a2t t < x1 a + at+ a t + b t x x t < x 2 2 ( ) 2 = + + ( ) ( ) Yt () a0 at 1 a2t + b1 t- x1 + b2 t- x2 x2 t < x3 (4.7) M M M a0 + at 1 + a2t + b1( t x1) + b2( t x2 ) bk ( t xk) t xk Here, Ytis () the yield on a bond with t months to maturity, a 0, a 1, a 2 and b 1, b 2,..., bk are constants and x 1, x 2,..., x k are the specific locations called knots at which the functions are 16

18 joined together. k is the number of knots. It can be shown that the piecewise function and its first derivative is continuous at the knots and thus the piecewise function is continuous and has no kinks. The above piecewise function (4.7) could also be written as following using the plus function. k 2 () = ( ) i= 1 Y t a a t a t b t knot + ( ) 2 i where, for any number y, ( y) + 0 y < 0 = y y 0 Once the knots are chosen over the data range, then the constants a0, a1, a2 and b1, b2,..., b k can be estimated using regression. Then using estimated parameters, the piecewise function can be used to find the interest rates for different maturities. Since the longest bond available was a 12 year bond, a flat yield of 5.8 per cent was assumed after 15 years. Figure 3 illustrates the estimated term structure of interest rates. Figure 3: Estimated Term Structure of Australian Interest Rates Observed Yield Fitted Curve Interest Rate (%) Years to Maturity As seen from figure 3, currently Australia is experiencing an inverted yield curve Generally inverted yield curve is often considered to be a predictor of economic recession. However this may not be the case in Australia. Ford and Taylor (2005) argues there could be other factors affecting yield curve such as the structural decline in inflation and inflationary expectations, excess global savings (the global savings glut hypothesis) and changes in the portfolio preferences of investors that putting downward pressure on long term bond yields. Further discussion on this topic can be found in Stock and Watson (2003) and Oliver (2006). 17

19 Survival probabilities Finally, in order to quantify the cost of adverse selection arising due to mortality differences between the general and annuitant populations 11, separate life tables must be constructed for each population. Population survival rates The survival rates for general population are computed using period life tables published by the Australian Government Actuary (AGA). The AGA updates their life tables every five years, soon after a general census. The latest available are the Australian Life Tables (ALT) These are based on the mortality of Australians over the three year period centered on 2001 Census of Population and Housing (AGA, 2004). In order to calculate the money s worth, the life tables must be first aged up to The formula given by (4.8) is used to age the current period life table up to I x qx(2006) = qx(2001) 1 + (4.8) 100 Here qx(2001) is the probability of a person aged x dying before reaching age x+1 in year 2001 as reported in ALT , qx(2006) is the probability of a person aged x dying before reaching age x+1 in year 2006 and I x is the future annual mortality improvement rate at age x. This analysis assumes the 100-year future mortality improvement rates reported in ALT Once the period life tables have been aged they are transformed into cohort life tables. A cohort table is used to calculate the money s worth ratio as opposed to period tables, since annuity prices are based on projected mortality of the annuitant rather than the prevailing mortality rates on a cross section of ages at time of annuity purchase. For instance, an annuity provider who sells an annuity to a 65 year old will use the projected probability of a 65 year old dying in a particular age, say 70, having survived to that age, to price the annuity rather than mortality rate of current 70 year olds as given in period tables. The formula used to cohortise the period table is given by (4.9). 11 Annuitant population is a sub population in the general population who voluntarily purchase annuities. 18

20 $ I x+ t qx+ t( t) = q x(2006) 1 + (4.9) 100 t Here, q $ x+ t( t) denotes the projected probability of a x year old in 2006 dying at age x + t, having survived to that age. After preparing the cohort tables, the mortality rates are then converted to monthly rates (since annuity payments are made monthly, not annually) using formula (4.10), which assumes a uniform distribution of death. q = k q where k = 1 12, 2 12,...,11 12, 1 (4.10) k x x Finally, cumulative survival probabilities t surviving until x + t ) are calculated using (4.11). ( ω x) ( ) ( ) k+ t x k x x+ t t= 1 p x (i.e. the probability of a person aged x p = 1 q 1 q where t is an integer and k is defined as in (4.10) (4.11) Figures 4 and 5 illustrate the cumulative survival probability curves for males and females. Annuitant survival rates In addition to the general population cohort life tables, annuitant cohort life tables are needed to estimate the cost of adverse selection. Annuity life tables are the mortality tables (relating to the annuitant population) and are used by annuity providers in pricing their annuities. Theoretically, annuity mortality tables are constructed using past experience of annuity providers. However, due to the thin Australian annuity market there is not sufficient data to directly estimate the mortality rates for Australian annuitants accurately. The industry practice is to use annuitant mortality tables from countries that have large annuity markets such as UK, and then adjust the rates to approximate their own company experience. Two annuity tables are constructed - one based on the solvency standard set out by the Life Insurance Actuarial Standards Board (LIASB), which from here on will be referred to as Annuitant table (SS) and a second mortality table based on the assumption used by the annuity providers which from here on will be refereed to as Annuitant table (IS) 19

21 According to the solvency standards established under the Life Insurance Act 1995, the LIASB assumes that the mortality experience of Australian annuitants can be estimated by taking a percentage of IM/IF80 ultimate tables compiled by the Society of Actuaries, UK. (See Appendix G for more details) However when compared with the mortality tables used by the annuity providers, the LIASB assumptions seems to be somewhat conservative. As a consequence the second annuitant mortality table was prepared annuitant table (IS), using the assumptions used by AMP, Australia s largest annuity provider, to estimate their annuitant mortality rates. In their 2005 Annual Report AMP report that they assume 72 per cent of the IM/IF80 C10 life table compiled by the Society of Actuaries, UK for pricing purposes in Since AMP is the largest provider of life annuities in Australia with a market share of around 46 per cent in 2006, AMP s annuitant mortality experience is considered to be a good estimate for the Australian annuitant mortality rates. Figures 4 and 5 illustrate the cumulative survival probability curves for male and female annuitants using both the solvency and AMP assumptions. A significant difference in the annuitant mortality rates is observed under these two assumptions. Assuming industry knows better, it can be considered that money s worth results calculated using IS tables would provide a more accurate account of the Australian annuity market than those calculated using the SS tables. 20

22 Figure 4: Cumulative Survival Probabilities for a Male from 1941 Birth Cohort Cumulative Survival Probabilities Annuitant (SS) Annuitant (IS) Gen Population Males Age Figure 5: Cumulative Survival Probabilities for a Female from 1941 Birth Cohort Cumulative Survival Probabilities Annuitant (SS) Annuitant (IS) General Population Female Age 21

23 3.2 The Money s Worth Results The estimates of the money s worth of Australian annuities are based on the annuity quotes, interest rates and mortality rates as derived above. The results are presented in Table 2, which summarizes the money s worth estimates for six alternative annuities, where the annuities are purchased by males, females and jointly by a couple. Further to any assumptions made in section 3.1, the results presented here assume: Income received from annuities is tax free per cent flat rate of inflation, which is the average inflation for the last five years (2001 to 2006). Last survivor annuities are jointly owned by a 65 year old male and a 60 year old female, and 85 per cent of income is payable to the survivor. Table 2: Moneys Worth Estimates for a 65 Year Old in 2006 Mortality Table Nominal Nominal (10yr guarantee) Annuity Types 5% esc 5% esc (10yr guarantee) CPI Index CPI Index (10yr guarantee) Males Population Annuitant table (SS) Annuitant table (IS) Females Population Annuitant table (SS) Annuitant table (IS) Last Survivor Population Annuitant table (SS) Annuitant table (IS) This assumption can be justified by the fact that in 2006 almost 72 per cent of life annuities were bought using ETP monies, thus qualifying them for 15 per cent annuity rebate - which effectively makes annuity payments tax-free for most annuitants (see example in Appendix E). As well, all retirement benefits for persons aged 60 and above will be tax free from 1 July

24 Table 3: Total Loading on Annuities for a 65 year old in 2006 Nominal Nominal (10yr guarantee) Annuity Types 5% esc 5% esc (10yr guarantee) CPI Index CPI Index (10yr guarantee) Mortality Table Males Population Annuitant table (SS) Annuitant table (IS) Females Population Annuitant table (SS) Annuitant table (IS) Last Survivor # Population Annuitant table (SS) Annuitant table (IS) # Last Survivor annuities assumes, a 65 year old male, 60 year old female and 85% of the income is payable to survivor Table 4: The Cost of Adverse Selection for a 65 Year Old in 2006 Nominal Nominal (10yr guarantee) Annuity Types 5% esc 5% esc (10yr guarantee) CPI Index CPI Index (10yr guarantee) Mortality Table Males Annuitant table (SS) Annuitant table (IS) Females Annuitant table (SS) Annuitant table (IS) Last Survivor # Annuitant table (SS) Annuitant table (IS) # Last Survivor annuities assumes, a 65 year old male, 60 year old female and 85% of the income is payable to survivor 23

25 Table 5: The Cost of Adverse Selection as Percentage of the Total Loading for a 65 Year Old in 2006 Nominal Nominal (10yr guarantee) Annuity Types 5% esc 5% esc (10yr guarantee) CPI Index CPI Index (10yr guarantee) Mortality Table Males Annuitant table (SS) 21.0% 18.3% 22.3% 20.8% 17.7% 16.0% Annuitant table (IS) 15.9% 13.3% 15.7% 14.3% 12.8% 11.3% Females Annuitant table (SS) 12.5% 10.7% 14.5% 13.5% 10.6% 9.6% Annuitant table (IS) 7.5% 5.8% 7.4% 6.5% 5.8% 4.9% Last Survivor # Annuitant table (SS) 12.8% 11.8% 15.6% 12.5% 11.4% 10.8% Annuitant table (IS) 8.6% 7.6% 9.1% 7.2% 7.0% 6.5% # Last Survivor annuities assumes, a 65 year old male, 60 year old female and 85% of the income is payable to survivor Annuitant table (SS) Annuitant table (IS) annuitant mortality table constructed using solvency standards set by Life Insurance Actuarial Standards Board. annuitant mortality table constructed using industry standard. See text for further detail The results show that the loadings faced by an individual in the general population is much greater than those faced by someone in the annuitant population. There is no significant difference in the money s worth ratio for males and females in the annuitant population, although the loading faced by a male in general population is slightly higher than the loading faced by a female in the general population, suggesting greater adverse selection for males than females. As well, the results show that the loading is larger for the 5% escalated and CPI indexed annuities compared to nominal annuities. This could be seen as an extra cost people should face in order to receive protection against inflation. Another result worth noting is that the single life annuities with a minimum guarantee period seem to offer slightly better deals compared to their counterparts without a guarantee period. The reason for this is that annuities with a guarantee period eliminate the uncertainty involved in payments up to end of the guarantee period. Thus individuals purchasing an annuity with a guarantee period are more likely to receive their money s worth (i.e. receive their investment back). 24

26 The results indicate that loading faced by a 65 year old male who purchases a single life annuity in the general population is higher than the loading faced by a same aged male in the general population who purchase a last survivor annuity with a 60 year old female (except for case with 5% escalation with a guarantee period). Further analysis revealed that same is true for a 60 year old female who purchases a last survivor annuity with a 65 year old male. Thus the evidence suggests that couples can significantly reduce the loading they face by purchasing joint annuities. Overall, the results indicate that the costs of adverse selection for Australian annuities are significant and that the estimates are dependant upon the mortality assumptions. The estimates derived using annuitant table (SS) the solvency standard assumptions - are significantly higher than the selection costs obtained using the annuitant table (IS) the industry standard assumptions. Further, the calculations revealed that under the solvency standard annuitant mortality rates, adverse selection accounted for an average 19 per cent of the loading for males and 12 per cent of the loading for females. Under industry standard annuitant mortality rates, this was 14 per cent for males and low as 6 per cent for females. (see Table 5) When compared with international experience, the results indicate that the total loadings for Australian annuities are much higher, at around per cent, compared with the 14 per cent loading reported in Brown, Mitchell and Poterba (1999) for a male in general population in US. However, adverse selection cost as a percentage of the loading was significantly lower for Australia than internationally. Estimates indicate that the cost of adverse selection as a percentage of the total loading in Australia is in the range of 5-22 per cent, compared to 85 per cent reported by Brown, Mitchell and Poterba (1999) for US. Similar comparison can be made for results reported by Finkelstein and Poterba (2002) for UK and James and Vittas (1999) for Canada and Switzerland (see Table A1 Appendix A). This suggests that more of the loading in Australia is due to administrative costs, profit margin and other similar factors. Also when compared with previous money s worth calculations for Australian annuities, it appears that the money s worth of Australian annuities have dropped significantly. For example, using 2000 data Doyle, Mitchell, and Piggott (2004) reported a money s worth ratio of 0.88 for a male and 0.9 for a female from the general population who buy a nominal annuity. (see table A2 Appendix A). by comparison, the estimates presented here suggest 25