INTRODUCTION. JONATHAN CALLUND General Manager Callund y Compañia Ltda, Chile

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1 JONATHAN CALLUND General Manager Callund y Compañia Ltda, Chile INTRODUCTION I have been asked to talk about my experience in the annuity markets in the Region and in particular four specific discussion points: - What has been the evolution of the annuity markets in recent years? - The pros and cons of obliging members to purchase an annuity mandatory? - What has been the degree of member satisfaction? - How do the systems of annuities compare among themselves? This is tall order in an hour, especially given that I am the only one talking about Latin America and, there is a lot of basic material to cover before we can get round to addressing these issues. However, given that the presentations yesterday covered many of concepts and in some depth, I will be spending a good deal of my time explaining the background to the AFP system in Chile and the practical issues of annuity market there. This will assist us in understanding the conditions of the other markets. I will then look at each of the other selected markets, comparing them with Chile, before moving on to the two policy questions, namely whether or not it is a good idea to give the pensioner an alternative to the annuity and what has been the effect of these young systems in terms of benefits to the consumer. I would then plan to leave around 10 minutes for questions. I will be looking at four annuity markets, namely; Chile, Argentina, Peru and Mexico. These are the most relevant ones and provide a broad range of variations on a similar theme. I will also be touching, although only briefly, on the conditions in Colombia and Brazil. I gave an earlier version of this paper at another World Bank conference on annuities in Mexico City in That event has since allowed me to follow the development of the Mexican AFORE system and the dynamic annuity market that has come into being there over the last two years. Now for some background on me and my firm. I have been in Chile since 1993 and have followed the development of the annuity market there from a number of different angles: - In carrying out feasibility studies and actuarial work for foreign investors, my firm has been involved in setting up a number of annuity companies. - As employee benefits consultants, we advise employers on how best to make use of the AFP system and assist them in setting up pension plans to supplement the mandatory contributions, especially for executives. - As financial planning consultants, we counsel individuals on the way to save for old age and how best to arrange for a pension in the AFP system, whether as programmed withdrawal or an annuity. We have also worked in Argentina and Peru, assisting the government in developing the regulations, medical commissions and insurance market conditions for the survivors and disability pension systems. 41

2 This group insurance product is probably the most important area for the development of an annuity market in the early days of an AFPtype system, as old age pensions do not develop until at least 10 years after the system has begun. This is because the seniors, let s say the over 45 year-olds, in the working population, will tend to remain in the pay-asyou-go system there is simply not the time necessary for these individuals to develop the capital sum to purchase an annuity. PENSION REFORMS IN THE REGION Excluding Brazil and Venezuela, all the large countries and many of the smaller ones in Latin America have implemented a Chileanstyle, non-state pension fund system. Chile started the ball rolling with the launch of the AFP System on May Day, It then took over twelve years for the next country, Peru, to follow suit. That was in mid Colombia and Argentina followed in 1994 and then Uruguay in April In 1997, both Bolivia and Mexico initiated their own modifications of the system and as recently as April last year, El Salvador joined the fold. Statistics on the Reformed Regional Pension Systems Table 8: Regional Pension System Data (December 1998) ( ) Country Start Date Members Pensioners Funds (US$ m) CHILE May-81 5,950, ,613 31,029 PERU Jun-93 1,965,136 13,842 1,786 COLOMBIA Apr-94 2,702,257 2,787 1,767 ARGENTINA Jul-94 7,067,123 37,813 11,526 URUGUAY Apr ,517 n/a 374 BOLIVIA May ,267 n/a 276 MEXICO Jul-97 13,827,674 24,955 5,508 EL SALVADOR Apr ,972 n/a n/a TOTAL 33,005, ,010 52,267 Source: PrimAmérica Consultores According to the latest statistics produced by my friends at PRIMAMÉRICA CONSULTORES, in March 1999 these nine systems accounted for over 34 million members, of which around 21 million were making regular contributions. This compares with only 530,000 members (less than 3%) who currently draw pensioners. Around 80% of these pensioners are in Chile. According to the same source, the total funds under management at the end of 1998 were US$52 billion. According to a recent SOLOMON BROTHERS study, the total funds in the Region are projected to grow to US$360 billion by the year This is a considerable amount of money and is a very good starting point for the development of an annuity industry in the Region. As we all know, the basic premise of a capitalization system of the type that has now been implemented throughout the subcontinent (and many other parts of the world most recently in Poland where a new system started only two months ago), is that there are two distinct stages: Two Stages of a Capitalization System - The accumulation period, during which the employees place their State-mandated (and voluntary) savings for old age with an AFP, AFJP, AFAP, AFORE, or what ever the private sector fund manager happens to be called, with a view to them being invested in the capital markets, generating real returns, so as to create a sufficient funds with which to retire. - And, at that moment the second stage, the pay-out period or decumulation (as Dimitri Vitas referred to it in a recent paper in Chile) begins. This, then, is primarily where the annuity comes into its own, although, as we shall see a significant number of annuities will be bought before normal retirement age, i.e. in the case of disability and death. For obvious reasons, the new systems in the Region have all but focused exclusively on the accumulation period, i.e. assuring the efficiency of the fund managers, optimizing the return-to-risk function of the investments, 42

3 ensuring the correct collection of contributions, controlling the commercial practices of the agents and fund managers and, in general, minimizing costs. Few of the systems have matured sufficiently to generate any significant concerns over annuities, i.e. the vast majority of members are still active contributors and there are few pensioners. By all accounts, then, this is an issue that has yet to be looked at (and is clearly the prime reason for an event like this conference). Annuities in Argentina In Argentina, in March 1999 there were 42,000 pensioners, of which only half of the 28,100 survivors pensioners were drawing an annuity the rest are drawing programmed withdrawals. Figure 16: Pensions in Argentina (March 1999) Old age 19% Total of 42,051 Figure 14: Private Pensions in the Region (March 1999) Disabled 14% Survivors 67% Argentina 8% Peru 3% Mexico 6% Colombia 1% Chile 82% By all accounts, the only AFP-type system where there are pensioners in any number is Chile. Figure 15: Pensions in Chile (March 1999) Total of 446,364 Survivors 27% As for the 6,000 disabled pensioners, all of these are still in the 3-year transition period prior to confirmation of their disability by the MEDICAL COMMISSION. These members currently receive pensions from the specialized insurance company providing the group disability and survivors pension insurance cover to the AFJP. As regards the old age pensioners, there are a few some 8,000, but only 50 of these have opted to purchase an annuity, the rest are drawing programmed withdrawals. Pensions in Mexico In Mexico, after only 24 months, or so, there are 30,000 pensioners in the AFORE system, all of which are drawing annuities. Old age 63% Disabled 10% By March 1999, there were around 450,000 pensioners; 280,000 old-age pensioners, 113,000 survivors pensioners and around 57,000 disability pensioners. Of these, only around 60% - are paid as assured annuities, while the balance is being drawn down from the AFP system as programmed withdrawals. This compares with the annuities in Argentina. Figure 17: Pensions in Mexico (March 1999) Total of 29,864 Disabled 51% Old age 5% Survivors 44% In addition, there are around 4,000 pensioners under the workers compensation system, bringing the total to nearly 34,000. The distribution between disability and survivor s pensioners is about half-and-half. 43

4 Pensions in Peru A total of 15,200 pensioners in Peru (March 1999), of which 2,400 were old age pensions. Figure 18: Pensions in Peru (March 1999) Disabled 5% Old age 16% Total of 15,166 Programmed Withdrawal as an alternative to the annuity. In Chile, in addition to the US$32 billion (May 1999) in pension funds managed by the AFPs, the life insurance companies have already amassed over US$10 billion, or a third of the AFP funds in technical reserves on the books of the 23 annuity companies. Survivors 79% Most of these (80%) are survivor s pensioners. What s more, there are less than 800 cases of disability (after over 5 years!). The vast majority of these cases are in receipt of annuities under the special group disability and survivors pension insurance cover. Types of Pensions in the Region The fact that there are still so few pensioners is, in fact, good news, as the development of a sophisticated and solvent annuity market requires time and considerable preparation. The Chilean experience certainly shows this and, as with many other facets of the movement towards mandatory capitalized pension savings, Chile can provide other countries with a number of general lessons. Figure 19: Types of Pensions in Latin America (March 1999) Old age 54% Total of 536,236 Disabled 13% Survivors 33% Returning to the projections of the $360 billion in pension funds by the end of the next decade, this figure is more an indication of the projections of the annuity market, as the vast majority of these savings will, by definition, end up being transferred to annuity companies. Mind you, not all of the funds will be converted to an annuity, given considerations of State Minimum Pensions and the existence of the option of a THE CHILEAN ANNUITIES MARKET I will now spend around 20 minutes outlining some of the basic conditions of the AFP system that the affect the structure and dynamics of the annuity market. It will be seen that many of the same concepts have been adopted in the other countries. This will help us when we come to compare the conditions and look at the specific issues I have been asked to cover. The Pension Methods The Chilean system provides for disability, old-age and survivor s pensions, offering the member or his surviving dependants a choice of three pension methods: - Retiro Programado - Programmed Withdrawals also referred to as Systematic Withdrawals in the US or Income Draw- Down in the UK, - Renta Vitalicia Inmediata - Immediate Annuities, - Renta Vitalicia Diferido con Renta Temporal - Deferred Annuities with Temporary Withdrawals. In the Chilean AFP system, the annuity is an option. - Programmed Withdrawal, under the programmed withdrawal (PW) method, the funds are retained in the member s AFP account. It is the AFP which assesses the level pension (in indexed units of account - Unidades de Fomento) each year as an actuarial function of the member and dependants ages and sexes, such that the fund 44

5 will be completely drawn down over the expected remaining life-time. During this period the fund continues to accrue the full returns generated by the AFP (less any expenses, if the AFP makes a charge). At any time, the member, or in the case of his death, his dependants may opt for one of the other two methods. - Annuity, The immediate annuity is a pension method whereby the member agrees to transfer the balance of his pension savings account as a lump-sum premium to one of the life insurance companies in return for a lifelong guaranteed monthly payment (in this case indexed in Unidades de Fomento) from the moment of signing the contract and the subsequent payment of the survivors pensions, if applicable. This insurance contract is irrevocable and is based on a standard policy conditions, approved by the SUPERINTENDENT OF INSURANCE. - Deferred Annuity, the deferred annuity with temporary withdrawal method entails member contracting to receive a guaranteed annuity from a date in the future, as determined in the policy and retaining sufficient funds in his pension savings account to receive a temporary income from the AFP to cover the period from the date of opting for this method and the date on which annuity payments begin. There one important of condition to this hybrid arrangement - the deferred annuity may not be greater than 50%, nor less than 100% of the first temporary income payment. In addition to the basic conditions, the SUPERINTENDENCY has since approved a number of annuity riders: - A guaranteed minimum period of payment, say 5 or 10 years, - Repayment of the initial capital know as the Refund option in the US, and - the possibility of improving the contingent survivor s pensions above the legal 60% up to a maximum of 100% of the policyholder s pension. A profit-sharing endorsement was approved in 1988, but it was subsequently withdrawn. It is important to note that the annuity option may only be taken by those members who are able to contract an annuity which is greater than or equal to 110% of the State guaranteed minimum old age pension. This accounts for a large number of low-income members or those with a poor contribution record, being obliged to draw a PW. Table 9: Comparison of Programmed Withdrawal with annuity Programmed Annuity Withdrawal Member may change Irrevocable contract. AFP or switch to an annuity. Pensions are Pension is fixed at recalculated annually. the outset. The rate or return is not guaranteed. The rate of return is guaranteed. No longevity insurance. Life-long payment of pensions. Managed by an AFP. Managed by an insurance company. Gives rise to inheritance No rights to on death Pensions tend to fall in time. inheritance. Pensions are constant in real terms. In addition to the above conditions, the PW in Chile differs from the annuity in the following aspects: - In determining the value of the PW, the AFP makes no consideration for the cost of the contingent funeral grant (UF15 or around US$450), payable on the member's death. - The rate of interest applied is based in part (80%) on the returns made by the AFPs on the pension funds over the last 10 years and the average annuity rate in the previous calendar year (20%) the rate used this year is around 6% p.a. This compares with the prevailing market annuity rates of around 5% p.a. - No consideration is given to expense margins, e.g. administration costs, brokers commissions and profit margins these 45

6 currently amount to around 1.5% in the annuity market. Furthermore, other than the technical aspects, the convenience of the PW include: - The attraction of earning a better return in the short term on the balance of the individual account than that offered by the life office in the long term the unit value of the pension funds has risen by over 10% in real terms so far this year. - The attraction of retaining control of the balance of the member's account, in the case of early death - the balance up to UF4,000 (around US$120,000) is tax free when transferred as part of the member's estate. - The attraction of not having to draw down the full amount of the pension, something which is not possible with an annuity. This benefit offers considerable tax advantages to members with alternative sources of income, permitting the accumulation of tax sheltered capital gains until a pension is drawn, or leaving the balance to be paid over to the member's estate. - The potential of increasing the level of pension due to a change in the family group. For example, premature death of the spouse or the member himself will inevitably lead to a higher pension for the survivor than any offered an annuity contract. In summary, the PW is a very competitive product when compared with the annuity. However, it involves the member retaining both the longevity risk and the investment risk, whereas with the annuity contract both of these risks are ceded to an insurance company. This means that the AFPs, in Chile at least, are seen as competitors of the insurance companies. Although at the outset, for a healthy retired member, the PW may well probably be the best option, the big question is when should the member switch to annuity? The longer he leaves the decision the smaller will be his balance. The annuity rates will also work against him as times goes by, i.e. the Mortality Drag to which David Blake referred yesterday. Early Retirement and the Bonos de Reconocimiento These are two issues in Chile, which are not so relevant in the other markets. Early retirement in the Chilean annuity market is of great importance. These annuities have come to represent over two thirds of all annuities sold. Annuity Sales by Type of Pensioner The possibility of retiring before the legal retirement age is a legal and financial quirk. A male member may retire before age 65 if the balance in his AFP account is sufficient to purchase an annuity equal to 50% of his average wage over the previous ten years. What s more, if the balance is sufficient to purchase an annuity of more that 70% of the average wage, then the law allows the member to draw down the balance as a lump sum (Excedente de Libre Disposición). An added attraction of this is that it is virtually tax-free! With this, the early retirement option and the "Libre Diposicion" rule provide the member with a strong incentive to retire as soon as possible (and, most of the time, without giving up his job) and so to opt for an early retirement annuity a second source of income. Another important structural aspect of the Chilean system is the existence of the Bono de Reconocimiento and the possibility for the member to endorse the bond and sell it in the secondary market. The "Bono" represents the periods of contributions registered in the "old system" by those employees who switched to the AFP System. The Bono is nominative, and is held by the AFP as part of the member's individual account. Its value is expressed in pesos at the 46

7 date the member joined the AFP System, and it accrues a real interest of 4% p.a. The Bono and the interest accrued is payable the day the member reaches the normal retirement age, or on death or being declared disabled, and it is then paid into the Cuenta de Capitalización Individual. By trading the Bono in, the member can release a large part (still over 60% in most cases) of his retirement savings to funds the cost of the pension. Without this possibility, early retirement would be virtually impossible. Recent calculations show that the Bonos still to be paid by the government will add as much as US$12 billion to future retirement funding. The Chilean annuity market has benefited significantly from this particular system for funding the government obligation. Such a situation does not exist under the Argentine and Mexican models. Even in Peru, where there are Bonos, the values are considerably smaller and they are not expected to have anything like the effect they have had, and will continue to have, in Chile. Death & Disability Cover (The Group D&D Policy) The system of payment of disability and survivor s pensions is complex. However, it is important, as it is one of the principle sources of potential annuities in all the systems under review. The conditions of the other three systems are, by and large, modification of the Chilean scheme. The D&D covers are provided under a special group insurance contract, taken out by the AFP to provide a defined benefit as, a percentage of average pay, to a member suffering from a disability or to his dependants in the case of death before the normal retirement age (Normal retirement in Chile is taken to be 65 for men and 60 for women). Disability Pensions In Chile a member is entitled to a disability pension if, after being evaluated by a specialized MEDICAL COMMISSION, his is found to have suffered a permanent loss of more than 50% (partial disability) or 2/3 rds (total disability) in working capacity. The approval process is done in two stages, i.e. all initial assessments are subject to a review after 3 years. The disability benefit is assessed as 50% (partial) and 70% (total) of average pay over the previous 10 years. During the first 3 years, the company that underwrote the group D&D policy with the AFP at the time of the claim pays the pension, without touching the member s balance with the AFP (or his Bono de Reconocimiento). Figure 20: Chile - Annuity Sales by Type (US$ Millions) Early Retirement Old Age Survivorship Disability Source: S.V.S. Annuities Statistics At the end of the 3-year period, assuming the Medical Commission confirms that the member permanently disabled, then the same Company pays the Aporte Adicional to the member s AFP account. This Aporte Adicional is equal to the difference between: - Capital Necesario - the technical fund required to finance the member's disability pension and potential survivors' pensions for his beneficiaries, based on the regulated mortality tables and a long-term rate or interest, and 47

8 - The accumulated balance (including the Bono de Reconocimiento) in the member s AFP account. At this moment, i.e. after 3 years, the member is free to opt between one of the three Pension Methods and may elect to purchase an annuity with the new (topped-up) balance in his AFP account. Survivor s Pensions On death, the member's dependants have a right to survivors pensions. These are determined as a percentage of the member s average pay: - 42% for a widow without children. - 35% for a widow while any children draw a pension % for each child to age 18 or 24, if in full-time education. The amount of the Capital Necesario is dependent on the actuarial present value of the contingent flow of the survivors pensions and the company then pays the Aporte Adicional. In both cases, the discount rate used in calculating of the Capìtal Necesario is the average market interest rate used by life insurance companies for AFP Annuities in the calendar quarter immediately prior to quarter in which the claim occurred. The mortality tables have been defined by the SUPERINTENDENCY, based loosely on Chilean experience: - MI85 (disabled mortality) - B85 (beneficiaries mortality). The Annuity Product Having looked at the basic conditions that give rise to the benefits under the mandatory pension system in Chile, we should now look at the conditions of the annuity as a financial product. The market data used in this sections is taken from a recent study prepared by Consorcio Nacional de Seguros Vida. beneficiaries of an irrevocable insurance contract that is underwritten by a registered life insurance company in Chile. Number of annuities policies Sold Insurance companies in Chile are divided into life and non-life companies. However, the life insurance companies need not be specialised in annuities, i.e. most tend to sell other traditional individual and group products. Figure 21: Chile: Number of Policies Sold 2,674 4,498 8,619 11,813 14,520 16,076 18,754 21,666 23,082 24,750 20, Source: S.V.S. Annuities Statistics The benefit of this contract is the life-long receipt of indexed pension, denominated in Unidades de Fomento (UF), which is a legally recognized unit of account, the value of which is adjusted daily in line with variations in consumer price inflation (CPI). The pension is payable monthly in advance. The premium for this contract is a lump-sum, comprising the balance of the member s account in the AFP, together with the cash value of the Bono de Reconocimiento. This sum is paid at the start of the contract. Chile Annuity Premiums The price of this insurance policy is expressed as a capital per monthly unit pension, for example, 165 units of capital per unit of pension, which is the average conversion rate at present and which is determined freely in the market. Under an AFP annuity policy, the AFP member, or his surviving dependants, are the 48

9 129 Figure 22: Chile - Annuity Sales (US$ millions) ,213 1,074 The purchase of an annuity can be made directly by the member or with the assistance of independent brokers or company agents, giving a right to a commission, the amount of which is stated in the policy document average commissions are currently over 5%. All pension payments are made directly by the insurance company, i.e. the AFP has no further dealings with the members once his balance is transferred to the insurance company. The Technical Reserves for Annuities The investment of a lump-sum premium received on the sale of an annuity is directly affected by the regulations issued by the Insurance Superintendent (SVS). These regulations are designed to accomplish the following risk management functions: - Avoid excess exposure to any one asset class (for example, over exposure to mutual mortgage units). - Avoid excess concentrations within any single asset class (for example, disproportionate holding in bonds issued by a particular company). - Eliminate certain classes of asset, which, due to the nature of annuity liabilities, do not provide similar cash flows or principal protection features (for example, equities). - Ensure proper matching by maturity and cash flows of liabilities generated with selected assets , Source: S.V.S. Annuities Statistics It is the last of these requirements, which creates the significant capital "strains" found in the annuity business in Chile. In the early years of the annuity business (prior to 1988), there were few competitors in the market and all annuities were written using the maximum technical interest rate of 3% p.a. real. Consequently, investment spreads were very large (4% or more). Asset selection, as a result, was concentrated in bonds and the capital strain was not a real concern. In 1988, the INSURANCE SUPERINTENDENCY introduced new technical reserve regulations (Regulaciones de Calce) aimed to encourage annuity companies to optimize the matching of their asset and liability flows, by requiring higher risk capital commitments when this did not. The regulations allow a company to set up 80% of its technical reserves using the market rate, in so far as the term of the assets and liabilities are matched. The balance of 20% of the reserves must, under all circumstances be valued at a conservative rate of 3% p.a. To do this, the regulations oblige companies to split all liability and asset flows into 10 periods ranging from 0 to 24 months (Range 1) to 29 years and over (Range 10). In practice, most annuity companies will be ale to arrange for perfect matching up to 15 or 16 years and some of the larger more established companies may do as well as 18 years. However, given the structure of investments available in Chile, none will be covered for period beyond 21 years, so creating a large degree of reinvestment risk and obliging the companies to use value the reserves conservatively and well below market rates. In practice, and despite the lack of suitable long-term investment instruments, the matching has permitted companies to establish reserves at rates closer to 4.5% p.a. real, allowing the companies to offer higher pensions. However, with commercial interest rates used for pricing annuities at over 5% 49

10 p.a., there are still significant capital requirements. As a rule, a difference of 1% in the between the commercial and matching rate will signify around 12% in capital cost in writing a new policy. Following these changes and with the arrival of more and more competitors in the annuity market, the financial spread has been progressively squeezed, falling from 2.6% in 1990 to 0.9% in Depending on the average term of the pension liabilities, the capital strain of the annuity business currently ranges between 4.5% and 10% of the single premium income, before payment of commissions and expenses. Mortality Tables The mortality tables used for all pension calculations in the AFP system are jointly regulated by the Superintendencies of Insurance and AFPs. As such, these are applied both in the determination by the AFP of the Aporte Adicional in the case of disability or survivors pensions as well as by life insurance company in rating and establishing the minimum technical reserves for the annuities. To-date all the tables have been non-selective, i.e. they are based on national statistics, without any specific sector adjustments. However, their application in the AFP system is selective, as only a part of the population is represented under the AFP system. The application of these tables in determining the minimum reserves for all annuities involves a potentially high degree of antiselection; - As indicated before, the better educated and higher socio-economic groups will tend to consider the PW option more than the lower paid retiring members. In this case, the mortality of the lower socio-economic groups, due to their access to health care facilities, work patterns and diet, will tend to be higher than the 'average' projected in the table. - The same can be said for those members who are unwell on retirement, i.e. whose own projection of their life expectancy is reduced. These members are likely to opt to stay with a programmed withdrawal, so taking this group out of the risk pool. In this case, without these good risks, the average longevity of a life offices portfolio will tend to be higher than that projected by the population table. This anti-selection will inevitably be a factor in the initial stages of any system. However, it is understood that the risk of anti selection in a portfolio of annuitants reduces over time. Over the last few year, the Chilean Insurance Association and the Insurance Superintendency have been working to develop a new table based on the 18 years claims experience of the AFP system. The new table - RV98 is expected to be introduced in the coming months. It is important to note that, this table will be applied to all new contracts, i.e. it is not expected to affect the value of the reserves for the existing portfolio of annuitants. What is more, the next project is the development of a table form rating the programmed withdrawals work on this is already well under way. The motivation for creating such a new table is to ensure that these calculations are done more precisely, as they directly affect the cost of the State in providing the guaranteed Minimum Pensions. Commercialisation of Annuities In traditional life insurance, products are focused on protection and/or replacement of income streams. In practice, few consumers of these products seek a company directly to provide these types of cover, hence the saying, that insurance is sold, not bought. With this, insurance companies have tended to develop a range of different distribution channels through which to contact the public and convince them of the need for such protection. Despite the cost, the majority of companies involved in these lines of business have developed a sales force of agents to place these products, given that this has 50

11 proven to be the most effective means of distribution. Figure 23: Chile - Annuity Interest Rates (Guaranteed Real Annual Returns) 5.01% 5.12% 5.16% In the annuities business, however, the situation is significantly different. On reaching retirement age or being declared disabled, the potential annuitant is actively encouraged to look for an insurer and, given the complexity of the market, most of them elect to use a broker or consultant to assist them in selecting the best company. The use of direct sales forces in the Chilean annuity markets is not common practice, although some of the larger companies do have them. The use of independent brokers is further enhanced in Chile, where the regulations oblige the annuitant to present quotations from at least three different companies. The principle elements determining the sale of an annuity via the brokers in Chile are the level of commissions and the amount of the pension offered. Other factors, such as company size, reputation, solvency, service and national origin are of considerably less importance. Figure 24: Chile - Brokers Commissions (% Gross Written Premium) 2.3% 1.6% 3.9% 3.6% 3.4% 2.9% 4.9% 4.3% 5.0% 5.3% Source : S.V.S. Annuities Statistics 4.76% 4.83% 5.09% 5.01% 5.56% Source: S.V.S. Annuities Statistics. 5.5% The commissions have increased considerably over the last few years, from around 1.5% of gross premium in 1988 to well over 5% today. Brokers Commissions This does not reflect a change in the services provided, but the demand from the pensioner to get hold of a cash sum on retirement and, in effect, commute part of pension. The system does not allow the member to take part of the balance as a lump sum (unless the pension exceeds 70% of salary). This being the case, the broker or agent is encourage to pay part of the commission over the to pensioner as part of the deal. On the other hand, the best indicator of the level of pensions is the guaranteed interest rate offered at any one moment. As we heard yesterday about the UK market and low rats, the Chilean situation is quite the reverse and despite the degree of reinvestment risk, average rates have consistently been in excess of 4.5% p.a. real, rising to 5.7% at the end of Chile Annuity Interest Rates These rates are guaranteed for an average term of over 15 years The Chilean Annuity Market Overall, the life insurance market in Chile has grown consistently since the beginning of the 1980's, reaching a total premium of US$250 million by Since then, the market has expanded exponentially, largely driven by the sale of early retirement annuities, which has accounted for over 70% of all annuity sales in the last five years. In 1998, the total life insurance market premium was US$1.6 billion, of which AFP annuities accounted for 64% or US$1.1 billion, in new business. In terms of assets under management, Chilean annuity companies reserves have risen from US$1.5 billion in 1988 to US$7.7 billion in December These are projected to increase at rates well in excess of 10% p.a., rising to US$37 billion by the year

12 The number of companies participating in the annuity market has increased from 9 in 1988 to 23 at the end of Similarly, the volume of premium has increased by an average of 40% p.a. over the period, despite having fallen for the first time last year. The heightened competition shows up in the fact that the largest five companies now represent a little over 40% of the market, compared with 98.5% in The expected number of potential annuitants has been projected using demographic data of members in the AFP system, and recent early retirement patterns. The projected flow of annuitants over the period of is as follows: Table 10: Projected Flow of Annuitants Year Number of Annuities ,000 p.a ,000 p.a ,000 p.a ,000 p.a. On the other hand, the projected annual premium flows are anticipated to grow as follows: Table 11: Projected Annual Premium Flows Year Number of Annuities 1995 US$1 billion 2000 US$1.9 billion 2005 US$3.3 billion 2010 US$4.9 billion Having looked at Chile in some detail, we now have model with which to compare the conditions in the other three annuity markets, namely: Argentina, Mexico and Peru. ANNUITIES IN ARGENTINA Argentina is probably the most sophisticated of all four markets and differs from the others in having had a form of private sector pension provision prior to their social security reform in July As such, there are two potential sources of annuities: - Those deriving from the special private system of Seguros de Retiro, which are made up of individual and group assured pension plans, and - Those deriving from the AFJP system. The former was an early attempt to resolve the social security crisis relying almost entirely on private initiative and tax incentives to create supplementary voluntary savings. The latter, the AFJP system was introduced in July 1994 and is closely based on the Chilean model, although with some key differences. The Sistema de Seguros de Retiro The Seguros de Retiro came into being in April 1987, with Superintendency Resolution , which authorized the creation of companies especially for this new line of business - Compañías de Seguros de Retiro. Given the lack any alternative system of longterm saving at the time (i.e. there was no way to supplement the State pay-as-you-go system), the new system developed rapidly and there were over 40 providers by the end of the first year. One of the main attractions of the new system was the tax benefit accruing to the premiums paid to these special insurance companies. Although this benefit was generous at the outset, it has been held at its current level of A$1,892 for many years now, making it now relatively insignificant for most employees in the middle and high income bracket. Despite the enthusiastic start, the economic and financial conditions towards the end of the 80 s and the beginning of the 90 s made life virtually impossible in the financial sector and, following a spate of M&A activity, by 1992 there were only 26 companies in this market. However, from day one, La Estrella, the largest Compañía de Retiro, has maintained its lead in this market and as at December 1998 still had around half of all the policies and the mathematical reserves. There are now 30 companies in the sector and the second largest is Siembra Retiro with a further 33% of the market. 52

13 The Seguros de Retiro are better understood as deferred annuities in the Continental European sense, where, for the payment of a regular (normally monthly) throughout the period of the contract, the policy holder acquires a right to a portion of a future pension, as of a date determined at the time the contract is drawn up. The conditions of the contract, in terms of the unit premium for the future pension are freely determined by the parties, considering the individual s age and sex, the type of annuity conditions and the age after which the pension is to be paid. This market can be divided into individual and group contracts. The former is effectively a competitor for voluntary savings to the AFJP system, whereas the latter is the most tax-effective and flexible vehicle for traditional corporate supplementary pension plans. As at December 1998 there were over 80,000 individual and 900,000 group policies in force, representing over US$1 billion in mathematical reserves (This compares with the US$11 billion held in the AFJP system). Despite an initial slow-down in the market following the introduction of the AFJP system, the rate of growth of new contracts and premiums is now strong again with increases of 13% and 25% respectively in Given that this system has been in operation for over 10 years, there is now a growing stream of annuities. However, the numbers are still very small. In 1998, 1,189 new annuity policies were sold, bringing the total number of policies in force to 5,639, of which only 83 are individual policies. AFJP Annuities The conditions of the AFJP system and the emerging annuity market are similar to those found in Chile and Peru, in the sense that at retirement, whether due to disability, death or old age, there are different pension methods. The Chilean option of a deferred annuity with temporary withdrawal does not exist. However, the Renta Vitalicia and Retiro Programado methods do. They also have a third option, the Retiro Fraccionado, which is obligatory for any member whose fund is insufficient to opt for one of the other methods, i.e. the member is allowed to draw down a fixed amount of around $115 until the balance is used up. Types of Pension - The Retiro Fraccionado is far and away the most common method for drawing and old age pension, with over 8,000 cases by March This compares with 50 cases of old age annuities. - As regards disability pensions, the vast majority of the 5,800 cases are still in the transitory period, awaiting confirmation of their permanent disability status. As such the pensions are being paid by the specialist insurance companies that can only underwrite the group disability and survivors pension insurance, the COMPAÑÍAS DE SEGUROS DE VIDA PREVISIONAL. It is these single line companies, and there are 18 of them responsible for paying the equivalent of the Aportes Adicionales to the member s account. During the 3 year transition period, these companies also pay the temporary pensions to the members declared disabled under a 1 st Ruling of the Medical Commission. - Finally, there were 28,000 survivors pensions in payment in March Of these, nearly 15,000 had opted for an annuity. The average lump sum premium of these contacts is in the order of $37,000. The top five providers of survivors annuities represent over 70% of the market premium. Annuity Policy Conditions The conditions of the annuity policy differ from those of the Chilean counterpart. In Argentina, the member is free to contract the annuity in A$ pesos or US$ dollars (which is now also the case in Peru). As price indexation is illegal in Argentina, since the passing of the Ley de Convertabilidad, pensions may only be held in nominal (A$ or US$) terms. This problem 53

14 is overcome by the use of profit-sharing clauses. The regulatory maximum technical interest rate is 4% p.a. real. The only way that a pensioner can increase his pension is by participating in the returns in excess of this 4% rate. The level of profit sharing is written into the policy and normally means the issue of a supplementary policy, guaranteeing the additional life-long pension, when the annual returns exceed the prescribed level. It is clear, therefore, that the Argentine reserving methodology does not consider the possibility of a higher discount rate in relation to the degree of matching (calce) between the asset and liability flows, which is the basis of competition in the Chilean annuity market. Another important difference is in the tables used in assessing the annuity. In Argentina there is no single table for assessing annuity rates and the corresponding reserves. These are proposed by the annuity company actuary and then presented to the Superintendency for approval as part of the technical basis of the particular policy. In practice, however, given the significant risks involved, the actuaries in the market have all tended to opt for one of two US tables (GAM 70 or GAM 90), depending on the type of annuity. With this, the basis of competition among the annuity companies is in the levels of profit participation offered to the client. This is good news for the insurer, as, by using a lower discount rate, the company reduces its reinvestment risk, sharing the returns with the annuitant. In practice, it is normal for companies to share up to 80% of the investment spread. ANNUITIES IN MEXICO Despite being the last of the countries to implement an AFP-type arrangement, it is quite likely that the Mexican annuity market will soon outstrip all the rest, both in number of policies and volume of investments. The Pension Methods As in all the cases before, the pension law allows the member to opt between an annuity or a PW on reaching normal retirement age. In the case of disability and survivors pensions, however, the law obliges the member or his dependants to draw an annuity, i.e. the PW is then not an option. Recognition of Contributions to the Old Pay-as you-go System The Mexican system for recognizing contributions under the prior social security system differs from all the other systems in the region. The State does not recognize any amount, such as the Bono de Reconocimiento in Chile and Peru. Nor does it guarantee a basic pension in respect of these contributions (as is the case in Argentina). However, it goes considerably further. In July 1997 all employees were obliged to switch to the new system. As compensation for this, the State now treats the rights to the pensions under the old system as an "acquired right". In this way, if an employee finds that the pension under the new system is inferior to the pension he would have received, then the State guarantees the original pension benefit in return for the balance in the member s AFORE account (but not including the SAR account). Otherwise, member is left to retire with the funds in the AFORE account and without any further State guarantees. This is the reason why there are likely to be very few old age annuitants in the forthcoming years. All these members will effectively cash-in their AFORE account and receive the original pension directly from the State. D&D Insurance Unlike in the other three systems, in Mexico the insurance market does not underwrite the risk and cost of disability and survivors pension claims. This responsibility is retained by the State, and it is the Instituto Mexicano de Seguridad Social (IMSS) that pays the equivalent of the Aportes Adicionales 54

15 known as the Monto Constitutivo. This is financed by a flat contribution of 2.5% of salaries, collected by the IMSS. On presentation of a disability or death claim, the IMSS pays a lump sum into the member s account sufficient to top-up the balance to equate with the Monto Constitutivo. This calculation is assessed using specially constructed mortality tables and a real technical interest rate of 3.5% p.a. The calculation also considering a one-time allowance of 3.5% for expenses. With this, the member or his dependants are obliged to purchase an annuity equal to the disability or survivors pensions defined in the law. 13 companies have been approved to operate in this annuity market and a 14 th is in process of being approved by the Comisión Nacional de Seguros y Finanzas (CNSF). The annuity market has only been in operation for 24 months. Given the structure of the system, there are two types of annuities those arising as a result of disabilities and survivor s pensions under the AFORE system and those deriving from accidents at work. As at March 1999 there were around 34,000 policies in force, of which 30,000 were AFORE pensioners and the balance of 4,000 were workmen s compensation claimants. The Product The legislation obliges claimants to select an annuity company to provide the guaranteed benefits. Only in the case of old-age pensions can a claimant draw a programmed withdrawal. The companies compete on the basis of products or services that they offer in addition to the basic pension. These additional benefits are also regulated by the CNSF and include: - Monthly inflation indexation - the law provides for an adjustment in February each year. - Life insurance. - Accidental death insurance, - Personal accident cover (including medical expenses), - Funeral expenses cover for the member. - A predetermined structure of life-long increases pension payments. - Family support - Educational support These and other additional benefits are permitted by the CNSF on condition that they are fully financed by the insurer and that the term of payment is the same as the annuity, i.e. life-long. The effect of these benefits is to ensure a high degree of consumer satisfaction, since they invariably receive a better deal than under the law. As at the end of 1998, the technical cost of the additional benefits in the market was assessed at around 4.4% of gross written premiums. Investments and the Technical Basis of the Policy As of this month (June 1999) all annuity reserves must be invested in inflation indexed instruments. This is a radical change and is even stricter than in Chile, where there is no obligation to be in Unidades de Fomento although the vast majority of the companies are) On receipt of the Monto Constitutivo the annuity company is obliged to set up a reserve on the same 3.5% basis in which it was assessed. In addition, all the companies are required to create a series of additional reserves, including: - A reserve for fluctuations in investment returns, to be constituted from 15% of earnings in excess of the 3.5% statutory rate; 55

16 - An additional reserve (de "prevision") of 2% of the base reserve, to compensate for any adverse mortality experience, and - A special mathematical reserve constituted out of favourable deviation between the actual vs. planned reserves (i.e. a positive deviation of more than 5%). - In addition to the reserves, the companies have to meet the additional marketing and administrative expenses leading to both accounting and financial loss on all new annuity sales. Figure 25: Mexico - Technical Reserves (Mexican $ Millions) 1,346 3,097 Over the last 24 months, the reserves have grown to $10 billion Mexican pesos. Commercialisation There are around 2,400 approved and registered pension advisers (in addition to each company s sales agents) who act as consultants and brokers in placing the annuity contracts. These professionals are monitored by the CNSF and obliged to complete at least 50 hours of formal training each year much like an IFA in the US. In fact, generous training courses are provided via the annuity companies. In addition, all the annuity companies have signed an ethical code of practice, to ensure they control their sales force and brokers. The rates of commission vary, but the market average in December 1998 was 1.9% of premiums. Market Volumes 5,357 7,391 9,933 Dec-97 Mar-98 Jun-98 Sep-98 Dec-98 Source: CNSF Pensions Insurance Statistics The MEXICAN ASSOCIATION OF INSURANCE COMPANIES (AMIS) has prepared a forecast of the volume of annuities resulting from the above two covers (Work Accidents and D&D). The average individual annuity in the forecast has a value (single premium) of about US$33,000. These values are smaller than the average single premium in Chile and about a third of the average value in Argentina... due in part to the lower average wage and in part to a lower level of benefits per case. The following is the AMIS forecast of the Mexican annuity market. Table 12: Mexico: Forecast of Annuity Market YEAR Projected Annuity Sales (US$ millions) 1997 $ , , , , ,170 Within five years or so it is easy to imagine an industry with over US$10 billion in reserves to invest. ANNUITIES IN PERU The Role for Annuities in the Pension System The annuity under the Peruvian AFP system is also an option, i.e. the member may elect a Programmed Withdrawal on the normal retirement age. However, an important difference between the Peruvian system and the others is the way in which survivors and disability pensions are arranged. As we have seen, in Chile, Argentina and Mexico, under the group disability and survivors pension programme, the member or his beneficiaries are given the option to elect an annuity once the Aporte Adicional is paid. In Peru the assured pension must always be paid directly by the insurer of the group policy, i.e. these companies offer two forms of cover: - The short-term risk that a member will die or become disabled, and - In that case on-going longevity and longterm financial risk cover throughout the 56

17 annuity payment period. This was the method used in Chile until Among other things, this has a significant impact on the development of annuities in Peru, as all disability and survivors pensioners do not come to market. This means that the only annuities really available are the old age annuities. At present, five different insurance companies underwrite the five AFP group D&D insurance policies. Despite a formal and public tendering process, over the last few years the owners of these five companies happen to be the same as own the respective AFP. With this, it is unlikely that the annuity market will develop in Peru at anything like the pace of the other three markets. Pensions in Peru The following table shows the development of the number of pensioners in each year and the stock of pensioners as at December 1998 and March Table 13: Number and Stock of Pensioners Year Old Survivors Disability System Age Dec Jan Feb Mar Total Distribution 16% 79% 5% 100% Source: SAFP This shows that nearly the insurance company that underwrites the group D&D risk is currently paying 85% of all pensions. Of the 2,400 old age pensioners, the majority are currently drawing programmed withdrawals. The Annuity in Peru Under an annuity contract, the member reaching retirement and or his surviving dependants, are the beneficiaries of an irrevocable insurance contract that is underwritten by a registered insurance company in Peru. Unlike the case in Chile and Argentina, Insurance companies in Peru are not divided into life and non-life companies. However, the regulations require companies to separate their activities and account separately for life insurance lines and annuities, including the group disability and survivors pension insurance. The benefit of the annuity contract is the lifelong receipt of indexed pension, denominated in Peruvian Sol. The value of the pension is subsequently adjusted every 3 months in line with variations in consumer price inflation in Lima. However, since the middle of 1998, companies have also been allowed to issue polices in US$ dollars. These policies will not need future adjustments. In this way, the initial vale of the US$ annuity is considerably higher than the equivalent Sol-denominated policies according to David Blake, with similar conditions in the UK, the initial difference may be as much as 30%. The premium for this contract is a lump sum, comprising the balance of the member s AFP account, together with the cash value of the Bono de Reconocimiento. This sum is paid at the start of the contract. The selection of the annuity provider is made via the members AFP, through a system of electronic pricing. No brokers and agents are involved and there can be no commission paid on the placement of the annuity. All pension payments are made via the members AFP, i.e. the insurance company has no direct contact with the pensioner. The annuities can be immediate or deferred. However, the regulations do no allow companies to offer any minimum guaranteed periods of payment. 57

18 Early Retirement and the Bonos de Reconocimiento As in Chile, the Peruvian law allows for a member to retire when his balance is sufficient to acquire an annuity of at least 50% of his average (previous five years) salary. However, these conditions are of no consequence to the Peruvian annuity market, given the relatively small size of the Bono de Reconocimiento. Even, if the Bono was a consideration, the law does not permit the member to endorse it over to the insurance company nor trade it on the secondary market. What is more, retirement ages are 65 for men and women and there are very few members within 10 years of this age. The Technical Reserves for Annuities The regulations governing annuities in Peru were issued by the SUPERINTENDENCY OF BANKS AND INSURANCE when the AFP system was implemented in 1993 and have not been revised since. The terms of the policy are based on those in Chile prior to 1988, i.e. there is no system of matching (calce) and all reserves are assessed considering a real technical discount rate of 3% p.a. Furthermore, the tables that are used are the Chilean tables: - RV85 (mortality of annuitants), - B85 (mortality of beneficiaries) and - MI85 (mortality of disabled members). The annuity calculation formulae are the same as those used in Chile, but considering the different reversion factors, as the levels or spouse, child and parents benefits differ from those in Chile. COMPARISON OF REGIONAL ANNUITY MARKETS Having reviewed the numbers and concepts, it will be clear that these four markets are in fact very different. Although all of them have implemented an AFP-type system, as with most things, the problems and opportunities are in understanding the detail and how this is likely to affect the development of each market. The following table compare the principal variables I have covered. Table 14: Condition Comparison among Chile, Argentina, Mexico and Peru CONDITION CHILE ARGENTINA MEXICO PERU Reserving Rate Matching-related 4% real 3.5% real 3% real (>4.5%) Indexation IPC / daily (Unidad de No IPC / 12 months IPC / 3 months Fomento) D&D Cover Annuities Annuities Annuities X Early Retirement Yes No No No Bono de Reconocimiento Yes No No Yes Who pays the pension Insurer Insurer Insurer AFP Brokers Yes / >5% Yes / >2% Yes / <2% No Programmed Withdrawals D&D Yes Yes No No Old Age Yes Yes Yes Yes Basis of Competition Pension % profit sharing Additional Benefits? 58

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