Mandatory Annuity Design in Developing Economies

Transcription

1 CENTRE FOR APPLIED ECONOMIC RESEARCH WORKING PAPER (2000/03) Mandatory Annuity Design in Developing Economies By Suzanne Doyle and John Piggott ISSN ISBN

2 Mandatory annuity design in developing economies* Suzanne Doyle and John Piggott University of New South Wales This version June 2000 *This paper was prepared at the request of Robert Palacios. We are grateful to him for the suggestion, and to Hazel Bateman, Geoffrey Kingston, Sachi Purcal, Mike Sherris, and Edward Whitehouse for extensive discussions and helpful comments. Matthew Williams provided inspired research assistance. Financial support under an Australian Research Council Grant and from the World Bank for related research, is gratefully acknowledged. Views expressed are solely those of the authors.

3 1. Introduction Pension policy has become one of the more volatile areas of economic reform in recent years. The onset of demographic transition, in developing and developed economies alike, has combined with concerns about the efficiency effects of a large public sector, to generate a search for pension reform options which reduce the legal responsibility of governments to provide financial support for the retired. A natural response is to find ways to increase self provision for retirement. This normally involves some minimum compulsory retirement saving, either by employees or their employers. Such schemes have been advocated by the World Bank, and have been adopted in a number of countries. Australia and Switzerland are among the developed nations to explicitly adopt such mandatory policies, while among developing economies, Chile has the most mature system. The model has been followed by a number of other Latin American nations, as well as several transition economies. 1 The retirement policies operating in these countries all entail private sector management of mandatory second pillar retirement accumulations. These are mainly of the defined contribution (DC), or accumulation type. Privatisation of social security has also been under active consideration in the US in recent years, and the UK has partially privatised its retirement policy provisions. The associated payout profiles in countries with mandatory retirement accumulations, however, have thus far been conditioned more by the pre-reform retirement policy status quo than by dispassionate consideration of sensible policy design. Yet it is the retirement phase where many of the financial risks associated with the elderly, which cannot be adequately insured against in an unregulated private market, are confronted. The most important are the risks emanating from uncertainty about longevity, investment and inflation. It is these, more than any other considerations, that underpin the economic case for central intervention in retirement provision in the first place. This paper explores the appropriate development of policy towards mandatory retirement income streams within this broad policy framework, paying particular attention to the economic 1 See Palacios and Pallares-Miralles (2000) for a complete list. 1

4 environments relevant to developing economies. We begin with a brief review of second pillar retirement benefit regulations. Broadly, we show that there is a strong tendency for mandatory retirement income streams to be associated with the defined benefit paradigm, and in turn for the defined benefit (DB) paradigm to be associated with unfunded social security schemes. Where public schemes follow a DC paradigm, benefits can usually be taken as lump sums, at least in some circumstances. As a result, the issues which arise in tying annuity type benefits to a DC type mandatory accumulation scheme have been under-researched. We introduce this topic in section 3 by discussing some broader regulatory and implementation issues concerning annuity markets which would need to be taken into account in implementing a mandatory annuity policy. Section 4 considers the potential market failures to which an unregulated and voluntary annuity market might be subject. In section 5 we provides an analysis of alternative annuity designs. Numerical simulation techniques are used to show how modest government-funded first pillar support and sensible second-pillar-funded annuity design might be sensibly combined (sections 6 and 7). 2. A brief review of benefit policy 2 Hannah (1986) reports that in the late 19 th century in Great Britain, the traditional life-cycle consumption smoothing model described the behaviour of the business and professional classes quite well. However, hunger and other needs pressing on low income workers through their working lives led them to discount the value of their future consumption to the point that little retirement provision resulted. Similar observations have been made about the US. Samuelson (1987) for example, asserts that in the century prior to 1937 the US was the richest country on earth, yet the bulk of its retirees relied on charity in retirement. These circumstances motivated the development of organised retirement plans. The best known of these are of course, the publicly financed plans which are now well established in most OECD countries. Known collectively as social security, they typically pay out a pension to the 2 In this section, Tables 1-4 and the associated text draw heavily on Palacios and Pallares-Miralles (2000), pp

5 retiree, with the payment depending on years of service and earning levels and patterns. They are tax-financed, either from consolidated revenue, or from some earmarked social security levy. Table 1 reproduces estimates of replacement rates, calculated by dividing average pension by average wages, for most OECD countries. The data on average wages for the OECD countries are taken from various sources. In most cases, the average pension is estimated by dividing total pension expenditure over number of pensioners. This last indicator was usually taken from national sources. Table 1: Replacement rates of public pension schemes High-income OECD countries Average pension as Average pension as Country Year share of average wage share of income per capita (percentages) Australia Austria Canada Denmark Finland Germany Greece Iceland Ireland Japan Luxembourg Netherlands Norway Portugal Spain Sweden Switzerland United Kingdom United States Sources: Palacios and Pallares-Miralles (2000), Table 4.6a, p. 37 Japan has the lowest replacement rates in the table, but this is partly because of ongoing maturation. The United States replacement rates are also on the lower end of the distribution. Regarding the difference between the two replacement rate definitions, we observe that in some cases the average wage is much different than income per capita. The less affluent countries in 3

6 the region such as Greece, Ireland or Spain have quite different numbers for both replacement rates. The definition of average wage might only refer to the formal sector. In order to assess relative income status of pensioners, the second definition of replacement rate might be more useful for cross-country comparisons. In other rich countries such as Switzerland or the United States, the replacement rates are quite similar under both definitions, and also quite low compared with other countries. Other countries such as Sweden, Finland, Germany and Austria are among the countries with higher replacement rates. Another replacement rate measure used in cross-national comparisons is the synthetic replacement rate. These are reported in Table 2. The figures refer to a stylised case where a full career worker s benefits are calculated according to the current benefit formula in each country. For all cases, it is assumed that the employee starts work at the age of 20 and that he has uninterrupted work until the standard age of entitlement to public pensions. The expected replacement rate at 55 is computed using pension rules prevailing at that age or announced changes in rules up to the standard entitlement age. The reported rates cover basic pensions, means-tested supplements and mandatory occupational pensions only. Under this alternative new definition of replacement rate, Japan and Australia are still among the countries with the lowest replacement rates. On the other hand, Greece, Portugal, and Spain seem to have some of the most generous systems, followed by Italy which observed a considerable increase of replacement rate since

7 Table 2: Expected old-age pension gross replacement rates: synthetic indicator Year Country Ireland Australia Netherlands Switzerland United Kingdom Canada Japan Czech Republic Poland Hungary Germany United States Denmark Finland Norway New Zealand France Belgium Sweden Austria Italy Portugal Iceland Luxembourg Spain Greece Source: Palacios and Pallares-Miralles (2000), Table 4.6c, p. 39 As a group, the high-income OECD countries have the highest public pension expenditures in the world. But as shown below in Table 3, there is significant variation within the group. Australia spends only five percent of its national income compared to three times as much in Italy. The source for the numbers we present below is usually the OECD Social Expenditures Database, For all countries, the numbers include old-age, disability, and survivors expenditures. 5

8 The correlation between the percentage of old population and pension spending is strong across countries. Italy, which has one of the oldest demographic structures in the OECD, also has the highest pension spending, followed by Austria, and France. Australia, Canada, Iceland, and Ireland have the lowest spending. Table 3: Public pension spending as percentage of GDP High-income OECD countries Pension Country Year Spending / GDP (percentage) Australia Austria Belgium Canada Denmark Finland France Germany Greece Iceland Ireland Italy Japan Luxembourg Netherlands New Zealand Norway Portugal Spain Sweden Switzerland United Kingdom United States Source: Palacios and Pallares-Miralles (2000), Table 4.2a, P. 29 Finally, Table 4 below presents several estimates of the implicit pension liabilities of various OECD countries. These liabilities represent different concepts of the present value of future claims against the government by workers and pensioners that belong to the public pension scheme. The estimates shows that outstanding pension liabilities, depending on the definition used, can be greater than conventionally defined public debt for many countries. 6

9 Table 4: Estimates of gross pension debt and general government debt, selected OECD countries OECD (1994) OECD (1996) IMF (1996) Kune (1996) IMF (1995) Kune (1996) General Govmt. Projected Projected Projected Projected* Accrued Accrued Gross Debt** Base Year Country Percent of GDP Austria Belgium Canada Denmark Finland France Germany Greece Ireland Italy Japan Luxembourg Netherlands Portugal Spain Sweden United Kingdom United States West Germany * Ignores future generation of workers ** General government gross public debt in 1994 from Mussa and Masson. Source: Palacios and Pallares-Miralles (2000), Table 4.2c, p. 32 The picture of future public liabilities depicted in Table 4 reflects promises of income streams in retirement which are indexed, at least to prices and sometimes to earnings; which are guaranteed to last until death, and frequently have generous survivor benefits; and which have been guaranteed by governments over periods of many years. They are intimately connected to the defined benefit nature of the promise, and to its pension, or annuity type structure. If lump sums had been promised at retirement, it is likely that the present values of the promises would be much less. Given the magnitudes reported, it is hardly surprising that there has been a retreat from these commitments. In various countries, parametric changes to the promises made, involving preservation ages, the nature of the indexation, or the nature of survivor benefits, have resulted in reductions in the present values of future liabilities. 7

10 The OECD countries are not alone in making these kinds of promises, however. Many other nations, in Latin America and elsewhere, have given similar undertakings to workers, especially employees. In these latter cases, however, the promises have been frequently broken. Estimates of replacement rates and projection of public liability therefore carry less meaning. Palacios and Pallares-Miralles (2000) discuss the pension arrangements of these regions in some detail. Some of these countries have sought to overcome financing and credibility problems in their defined benefit public provision schemes, by replacing these structures with mandatory DC type plans. By contrast, some developing economies, often those with links to British colonialism, have established what are generically known as provident funds to help finance retirement. These are essentially mandatory DC plans administered by the Government, sometimes through a separately established board of management, which maintain individual accounts for employees and which usually pay a lump sum, comprising the worker s net contributions and investment earnings, at retirement. Whether compulsory DC plans are administered in the public sector or the private sector, however, they bring with them the policy challenge of associated payout design. That this is controversial is evident from Table 5. It reports a wide range of payout designs and provisions, and largely bears out the view that payout patterns reflect what has gone before. 8

11 Table 5: Retirement benefits in countries with mandatory accumulation retirement policies Preservation age Benefit type Australia Chile Switzerland Current preservation age is 55 years for both men and women. To be increased to age 60 by Employees may access the accrued benefits either as a lump sum or as an income stream. Mostly taken as lump sum. Phased withdrawals (allocated pensions) are the most popular form of income stream. Men: 65; women: 60. Early retirement is permitted for high accumulations. Choice of phased withdrawals and life annuity. Lump sum withdrawals are permitted for high accumulations. Phased withdrawal compulsory if annuity greater than minimum pension unaffordable. So far, most retirees have taken life annuities. Preservation age is set at 65 years for men, and at 62 for women. Early access to accumulated benefit for home purchase. Benefits paid as monthly pensions. Lump sums may be available if small accumulations or for home purchase. No income stream choice. Reversion Not compulsory. Reversion is required Reversion is required. Replacement rate Integration with public safety net Taxation 40 year employment history, retiring at 65 years, 76% replacement for single male. This includes both annuity and public pension income. Poor integration. Preservation age not co-ordinated with public pension eligibility age. Dissipated lump sum not counted under means tests. Lump sums are taxed at 15% above an indexed threshold. Annuities and Superannuation pensions are taxed as ordinary income for all types of superannuation schemes, subject to 15% tax rebate Average replacement rates have reached 78% and have been higher for those opting for early retirement (82%). Well integrated with safety net. Minimum guaranteed pension to those with 20 years employment All of the pensions are subject to income tax but tax-free threshold is high. The BVG aims to increase total retirement replacement rate of average earnings from around 40% (under the public pillar) to 60% after 40 years of contributions. Well integrated with public pensions. Minimum pension guaranteed. Benefits subject to income tax. 9

12 Table 5 continued Argentina Peru Mexico Preservation age Men: 65; women: 60 Preservation age is 65 years for men and women. Early retirement possible Benefit type Reversion Replacement rate Choice of phased withdrawals and life annuity. Fragmented withdrawals are available for those whose accumulated funds are not large enough to allow for withdrawals equivalent to half the basic pension. Lump sum withdrawals are permitted for high accumulations. The dependents of a worker who dies before retirement are entitle to receive a survivorship pension, which is equivalent to a percentage of the worker s average income received in the five years prior to death. Basic universal pension set at about 27.5% of average salary. PAYG benefits calculated as percentage of average last 10 years earnings for each year of contributions. Funded scheme benefits depend on the level of accumulations. Well integrated with universal basic for high accumulations. Choice of phased withdrawals and life annuity. Also third option combining temporary phased withdrawals with a deferred annuity. Reversion is required. Benefits depend upon value of accumulation. Early retirement possible if the balance accumulated can finance a pension equivalent to 50% of average salary during last ten years. Integration with public safety net pension. No public pillar or minimum pension guarantee. Taxation Benefits subject to income tax. Pension contributions are paid out of after-tax income and pension benefits are also taxed. 65. Early retirement possible for high accumulations. Workers with 1,250 weeks contributions can opt to purchase a life annuity or to receive phased withdrawals from the fund, and government minimum pension guarantee applies. Workers with fewer than 1,250 weeks contributions are not entitled to minimum pension, but are allowed to withdraw balance of account as a lump sum if they prefer not to purchase annuity or take phased withdrawals. Reversion is required. Minimum pension is one minimum wage (about 40% of average earnings), for those who satisfy contribution requirement. Funded scheme benefits depend upon value of accumulation. Minimum pension guaranteed to those aged 65 and with 1,250 weeks contributions Withdrawals are not taxed up to a limit of nine times the minimum wage, and there is a higher limit for tax exemption when employees withdraw all their funds at once. 10

13 Preservation age Table 5 continued Colombia Uruguay Preservation age is 62 for men and 57 for Men: 60; women: 55, rising to 60 by women. Early retirement is possible for high accumulations. Benefit type Choice of phased withdrawals, purchase of a Life annuity only. life annuity, or a combination of both. If accumulated balance is sufficient to finance pension of 110% of minimum wage, excess capital may be used for purposes other than retirement. Reversion Reversion is required. Reversion is required. Replacement rate Integration with public safety net Taxation Minimum pension represents a replacement rate of around 60% of average earnings. Government guarantees minimum pension (one minimum wage, or about 60% of average earnings) provided reached official retirement age and contributed for at least 1,150 weeks. Pension benefits are tax-exempt up to the limit of 20 minimum wages. However, if funds accumulated in individual account are use for non-retirement purposes, taxes are due. Minimum guaranteed pension pays at least 50% of average salary of last 10 years, rising if retirement is postponed. Funded scheme benefits depend upon level of accumulation. Minimum guaranteed pension to those with 35 years of contributions at retirement age, or those aged 70 with 15 years of contributions. Benefits subject to income tax. 11

14 Preservation age Benefit type Reversion Replacement rate Integration with public safety net Taxation Table 5 continued Singapore Preservation age is 60 for both men and women. Lump sum may be available at age 55. Retirement account funds must be used to purchase a pension or annuity. Members may withdraw a lump sum at age 55 provided they retain a specified minimum sum in their retirement account. If a member dies, the full amount of the accumulation is available to beneficiaries. No explicit target replacement rate but scheme intended to provide members with an income of 20-40% of pre-retirement earnings, sufficient funds to meet medical expenses during retirement, and a home commensurate with their income level. 98% of Singaporeans over 21 are covered by Central Provident Fund (CPF). Strict means-tested safety net assistance provided to destitute aged and those not covered, or inadequately covered by the CPF Lump sum withdrawals at age 55 years are tax free. Normally pensions paid from age 60 years are also tax free, however any pension amount paid from contributions in excess of those required on a mandatory basis is taxed as income. Malaysia Full retirement benefits available at age 55, and partial benefits at age 50. Early withdrawals permitted for home purchase. Benefits can only be taken as lump sums. However the member can withdraw the annual dividend only or leave the funds in the account after age 55 and can continue to contribute. If a member dies, the full amount of the accumulation is available to beneficiaries. The average amount of the full withdrawal is about the same as one year of an annual salary for a typical employee. No public age pension. Means-tested benefits available to those aged 60 and over who are homeless or destitute and do not have families to support them. Benefits are untaxed. Source: Bateman (1997), Bateman and Piggott (1997), Davis (1995), Hepp (1990), Feldstein (1998), Barrientos (1998), Quessier (1998), Stanton and Whiteford (1998) 12

15 To make discussion about payout design more concrete, it may be useful to briefly describe the benefit types available in Australia, Switzerland and Chile, the three countries with the most mature privately administered mandatory accumulation schemes. Australia. Until the advent of mandatory retirement provision coverage in 1992 (known as the Superannuation Guarantee), Australia was almost unique among developed countries in having no second pillar. Mandatory contributions, payable by employers, are being phased in, and will rise to 9% of employees earnings by They currently stand at 7%. Before this, voluntary private sector occupational superannuation had quite low coverage, and benefits were mostly drawn as a lump sum. The practice of taking lump sums has continued under the Superannuation Guarantee. About 85% of the value of superannuation benefits are paid in this form. About 10% is taken as an income stream and the remainder is taken as a death, temporary or permanent disability benefit. Although income streams are not compulsory, they are encouraged through a variety of tax incentives and first pillar means test provisions. Retirement income streams which attract preferential tax and/or means test provisions can be broadly classified into immediate annuities (term certain and life annuities), superannuation pensions (life annuities from DB schemes) and phased withdrawals, which in Australia are called allocated pensions and annuities. Recently, amendments to first pillar means testing arrangements have served to encourage what might be termed life expectancy products. 3 These must guarantee an income stream for the life expectancy of the retiree at the time of purchase. There can be no commutation or residual capital value. Retirement accumulations used for these purchases are not counted in the assets test, one of two means tests applied to the first pillar age pension. 13

16 Allocated products are the most popular form of income stream. A maximum drawdown limit is set with the expectation that the account will be exhausted by the age of 80, while under the minimum level the account will last indefinitely (subject to diminishing withdrawals). Switzerland. Switzerland has traditionally had a standard OECD type three pillar retirement support policy. In 1985, another component was added to the second pillar, the BVG, which is a privately administered compulsory occupational scheme. This supplements the employment related social security pension, which is financed by social security tax payments from employers and employees. The two schemes combined aim to provide a total retirement pension of 60% of covered earnings after 40 years of contributions for the average worker. There is a means tested social-assistance pension for those on very low social-security pensions. Contributions for the BVG are required from both employers and employees, with the employer to contribute at least 50%. The contributions vary according to gender and age and range from 7% of earnings for the young to 18% of earnings for those approaching retirement. There are additional contributions of 2-4% for survivors and disability insurance, 1% to allow for the indexation of benefits, 0.02% for the security fund and 0.2% for administration. Benefits from both Social Security and the BVG are generally paid as monthly lifetime pensions. Alternative benefit designs are not available. For small BVG accumulations, lump sum benefits are possible, and early withdrawal of benefits for housing purchase is available under certain circumstances. Viewed as a DC plan, the BVG incorporates minimum requirements: a minimum contribution rate, a minimum rate of return, and a minimum annuity conversion factor. (Annuity factors must be gender uniform). The security fund guarantees minimum retirement credits and by covering DC as well as DB plans the Swiss guarantee arrangements 3 Statistical life expectancy of an Australian male retiring at 65 in 1998 was years and years for a female. 14

17 are unique in the OECD. Reversion is required. While the BVG is essentially DC based, many of the benefits actually paid exceed the minimum requirements and are formulated on a defined benefit (DB) basis. Chile. Chile s current second pillar retirement income policy was established in 1981, with the old social security system gradually being phased out. It is of the DC type, publicly mandated but privately administered. The government guarantees a minimum pension to workers whose accumulations fall short of set limits. The value of the minimum pension is adjusted by inflation every time the accumulated change in the CPI reaches 15%. First pillar support comprises a targeted social assistance scheme. A subsistence pension is payable through that scheme to those not eligible for the minimum pension. Retirees may make phased withdrawals from their individual account, regulated to guarantee income for their expected life-span; or buy an annuity to provide life-time benefits; or choose a combination. Phased withdrawals require reversion, but life annuities do not. Some lump sum withdrawals are permitted. However, this is only allowed if it still leaves enough in the account to fund a benefit that is a 70% replacement rate and equals 120% or more of the guaranteed minimum pension. Only 25% of the eligible retirees in Chile have taken lump sums. Of the current pension beneficiaries of the new system, some 44% have taken up a life-time annuity, although fees have tended to be high. The phased withdrawal is one of the most common income stream products in Chile. Accumulated funds are drawn according to an actuarially determined schedule. Any balance remaining after the beneficiary dies is inherited by heirs. Complete longevity risk is provided only insofar as the government will pay the minimum pension if funds are exhausted. 15

18 3. Infrastructure for secure privately provided retirement income streams Much economic advice from international organisations is predicated on the view that in practice, markets work well in the fundamental social task of allocating resources. It is worth taking a step back from immediate discussion of specific regulations relating to annuity issue, to ask what role any such regulations might, or should, play in facilitating resource allocation. For a price system to operate effectively in allocating resources efficiently in a sophisticated society, three prerequisites can be identified. Property rights must be allocated and enforceable; information about possible transactions must be available on a fairly general basis; contracts must be enforceable over time. These requirements lie behind the legal, administrative and regulatory environment that must develop to support a comprehensive annuity market. Viewed from this perspective, it is easy to see why the regulation of annuity issuers is so pervasive, and why it assumes so much importance. Property rights to pensions are frequently blurred by public regulations and complicated vesting conventions; relevant information is not common between annuity buyers and sellers; and very long time periods sometimes elapse between annuity purchase and the final payment promised by the annuity issuer, thus raising the real possibility of default, either explicitly or implicitly through changes in the interpretation of contingency obligations. Robust legal and reliable financial infrastructures are features of most developed economies. It is hard to see how long term saving and investment could otherwise be facilitated through market channels. Mitchell (1998) provides an accessible discussion of these issues, emphasising the evolving nature of legal and financial infrastructure. This is important, not only in thinking about practical implementation, but also in understanding how public confidence in such structures a necessary condition for successful retirement saving policy may gradually be developed. Administrative Reach Mitchell (1998) also points to the importance of record keeping. The administrative reach of any retirement provision policy, and by implication the extent of coverage, will obviously depend on official awareness of potential beneficiaries. At present, in most developing 16

19 countries, the existing schemes reach only a small proportion of the population. According to Iyer (1993), coverage in sub-saharan Africa typically represents well under 10% of the population, and rarely exceeds 50% anywhere. Coverage in Latin America, he reports, is generally higher but still very uneven - ranging from 10% of the economically active population in the Dominican Republic to complete coverage in Nicaragua and Cuba. Often these programs, when they were implemented, were aimed at the urban workforce, rather than the working population as a whole. As these countries develop, it is likely that the urban labour force will become proportionately more important, so that coverage will tend to rise automatically over time. At the same time, however, the informal urban workforce has been increasing in many of these economies, partly to avoid pension contribution and tax obligations. Financial Infrastructure Financial infrastructure comprises the legal and accounting procedures, the organisation of trading and clearing facilities, and the regulatory structures that govern the relations among the users of the financial system (Merton and Bodie 1995). These authors point out that successful public policy in this (and other) areas depends importantly on recognising what it is that governments can and can t do to promote economic efficiency. At a minimum, a regulatory framework for a robust banking system seems essential for annuity provision to be reliable, since intermediation, across time, size, and risk all functions of the banking sector -- is exactly what a person planning for his or her retirement requires, along with confidence in the institutions undertaking the intermediation in his behalf. Bank like institutions will need to be similarly robust. In addition, the existence of a well functioning stock market is likely to encourage greater diversification of investment, and thus improve pension performance in both the accumulation and liquidation phases. Numerous empirical studies of stock market returns have documented the gains in diversification from investing internationally. While international diversification is very desirable, strong pressures to invest domestically, thus thwarting international diversification, are often encountered, even in developed economies. If these pressures cannot be overcome, then in the absence of a domestic stock 17

20 market, the result is generally investment in domestic government bonds. These are rarely indexed, and the erratic inflation performance of many developing economies puts at risk the real value of accumulations as well as the performance of securities underlying annuity issue. Asher (1998) discusses this question, with the focus on accumulations, in the context of National Provident Funds. Mitchell (1998) offers commentary on stock market reform, and reports that there is no statistically significant relationship between a country s stock market capitalisation and the size of its pension market. Derivatives will have a useful role to play in pension reform in developing economies. For the time being, these markets are very incomplete, but this will change over time. Given the pressure to invest domestically, exchange rate risk, which is significant in many developing economies, might be insured against through foreign currency options. In the present global financial structure, however, such a strategy could presently be facilitated only by over the counter negotiations, and it is unlikely that very large values of these options could be purchased. Another suggestion for derived international diversification, due to Merton (1992), may have relevance for those countries with functioning stock markets. If capital controls (a form of domestic investment pressure) are taken as given, international diversification can be introduced by separating the capital flow effects from its risk-sharing aspects. This can be achieved through a swap type agreement. In such a swap, the total return per dollar on a small country domestic stock market would be exchanged annually for the total return per dollar on a market value weighted average of the major world stock markets. This exchange of returns could be in a common currency or adjusted to different currencies along lines similar to currency swap agreements. As with most swaps, there is no initial payment by either party to the other for entering the agreement. The swap agreement effectively transfers the risk of the small country stock market to foreign investors and provides the domestic investors with the risk return pattern of a welldiversified portfolio. Since there are no initial payments between parties, there are no initial capital flows into or out of the country. 18

21 Life Insurance and Annuity Issuer Regulation Annuity issue raises a number of specific regulatory concerns, addressed in the quite sophisticated mechanisms developed economies use to govern annuity issuers. This group of agents typically overlaps heavily with life insurance companies. Typically, life insurance regulations cover professional competence, reporting and disclosure requirements, reputation, and capital adequacy (or solvency). Credible regulatory authorities must be set up in countries contemplating the development of private life insurance and pension industries to ensure that annuity issuers meet these requirements. Often, the public sector will already be supplying these services. Effective privatisation of, or the introduction of private competition in, annuity provision should be implemented in ways that allow regulatory authorities to draw upon information already available from these public sector activities (Mitchell 1998). The sequence of privatisation and deregulation therefore needs to be carefully considered. Annuity providers are typically licensed and are limited in number. Privatisation may be best undertaken by initially implementing tight regulations, with gradual deregulation to follow as the market matures. For example, registered annuity issuers may each be allocated a basket of contracts, with price and conditions set by the regulator. Subsequently, migration between issuers at regulated transfer fees may be permitted, followed by some price deregulation. A parallel may be found in the Chilean approach to regulating investments in pension funds. Equity investments were not permitted until 1985, were limited to 30% of the fund s assets over and since 1995 are limited to 37%. International investment is now allowed. In many developing countries, life insurance services are protected from international competition. Outreville (1996), for example, reports that of 48 developing countries in his sample, 11 had a monopolistic life insurance market, 14 insisted on localised ownership, 17 required that life insurance be purchased from local issuers, and only 6 enjoyed an offshore market. The prevalence of protectionist policies is apparently motivated by externality and infant industry considerations. 19

22 However, constraints that local issuers in many developing economies must face - for example, undercapitalisation and lack of institutional experience and skilled personnel - create a dependence by these institutions on international services. Protectionist policies thus seem likely to hinder, rather than aid, the development of the industry, and thus the effective provision of retirement income products. For at least some developing economies, offshore annuity issuers could be contracted to develop the national market. An international tender process could be set up to provide annuity income streams for each cohort of retirees. It may be that international organisations such as the World Bank and the IMF can be instrumental in establishing regulatory frameworks and monitoring their operation, and that this will help credibility. Buttressed by appropriate legal and financial structures, such support could be instrumental in promoting confidence in institutions supplying annuity products. 4. Adverse selection and mandatory annuity purchase One of the most intractable issues in private market annuity analysis is the extent and nature of adverse selection. The primary efficient market requirement which is violated is commonality of information, that is, the annuitant can be presumed to know more about his life expectancy than the annuity issuer. In a voluntary market, this presumption leads to higher quotes on annuities than are actuarially fair for the population at large, and adverse selection sets in. Mitchell et al (1999) have analysed the moneys worth of nominal lifetime annuities offered in the US voluntary private market in They conclude that there is an average loading on single lifetime annuities of 18%. For a typical 65 year old male retiree with average mortality prospects, $1 worth of premium used to purchase an annuity will return an expected present discounted value of around 84 cents. Some of this loading is due to adverse selection, and some to overhead costs. Adverse selection accounts for around 10% of this loading. 20

23 Major annuity issuers in Australia use mortality tables reflecting the longevity of voluntary annuity purchasers in pricing annuities, rather than general mortality tables. Annuitant mortality tables are apparently used everywhere that the purchase of life annuities is voluntary. 4 Quotes from a major financial service provider suggest that in August 1998, allowing for commission costs, a 15 year term certain annuity is priced using a nominal interest rate of 5%. Using standard Australian mortality tables, corresponding quotes for a life annuity for a male aged 65 imply a nominal rate of 2.5%. The difference in the implied rates of return partially reflects adverse selection. Because of the compounding effect of discounting, the present value of a fixed single life annuity paying $1 a year will be lower than the present value of a $1 fixed term certain annuity where the term is set at life expectancy. The Australian quotes referred to above were (about) $9 500 a year for the life annuity, and $ a year for the term certain annuity, for a purchase price of $ The actuarially fair life annuity payout, assuming that the commission payments and rates of returns for the two contracts are identical, is more than $ Adverse selection has reduced the annual payout on the life annuity by about $2 400, or 20% of the actuarially fair value. For most retirees, these load factors are an effective deterrent to voluntary life annuity purchase. They suggest that adverse selection is pervasive in individual annuity markets. Given that individual tailoring of annuity contracts is infeasible, there is a strong case for mandating life annuities. Adverse selection is very limited when everyone must buy an annuity, provided appropriate restrictions are placed on annuity offers. Compulsion may 4 These are usually derived from the experience of voluntary annuity providers. In Australia, where annuity experience is limited, UK annuitant mortality tables are used. 5 These quotes encompass 3% escalation, which has been standard in Australia, and no residual capital value. 21

24 reduce commission costs, and in addition, mandatory annuities address the possibility of preference inconsistency in arranging finances through retirement. 6 Annuity mandation immediately raises the question of what features such instruments should have. In what follows, we examine the implications of alternative annuity products, suggested by Australian experience, both from the perspective of the retiree and from the viewpoint of government outlays. For simplicity, we focus on a male on some multiple of average weekly earnings with statistically average life expectancy, an assumption justified by mandatory annuity purchase. Reversion is ignored. The analysis is conducted in a policy environment which offers first pillar safety net support and mandatory private second pillar accumulations. 5. Characterising Life Annuity Products Table 6 lists the five different income streams on which we focus, and reports their salient features. The first annuity type listed is the conventional nominal life. The standard life annuity is specified with an escalation factor of 3% - equal to real wage growth - and other annuities have been modelled with this feature where appropriate. The life expectancy annuity is a term certain annuity set to expire at life expectancy about 15 years for a male aged 65 years. Other annuities require further explanation. 6 An alternative approach to limiting adverse selection has been put forward by Brugiavini (1993). She suggests incremental deferred annuity purchase throughout the accumulation phase, to exploit the observed feature of annuity markets, that adverse selection increases with age. A similar idea has been suggested by Boskin et al. (1988). Incremental deferred annuity purchase would also serve to spread annuity rate risk, since the terms of annuity purchase would vary with each increment purchased (Bateman and Piggott, 1999). 22

25 Table 6: Alternative annuity products Annuity Type Nature of Annuity Payout Nominal life annuity Life expectancy annuity Variable life annuity Phased withdrawal Inflation indexation Provides an income stream, constant in nominal terms, until death. Provides a prespecified income stream, constant in nominal terms, over life expectancy at time of purchase. Provides an income stream until death, with payments contingent on the market performance of some specified underlying portfolio. The AIR is set to generate an expected constant nominal income flow. Income can be drawn down at the retiree s discretion within a range specified by regulation; typically, maximum drawdown limits are set to exhaust resources by life expectancy from time of purchase. Provides an income stream with payments are indexed to inflation until death. Variable annuities provide insurance against longevity risk, while at the same time delivering higher expected returns by transferring investment risk to the annuitant. The annuity is written on the basis of an assumed investment return (the AIR). Payouts, however, are adjusted by the relationship between the performance of the underlying portfolio, which may be specified by the annuitant, and the AIR. Because investment risk is borne by the annuitant, the AIR may be significantly higher than the risk-free rate in our calculations, we have assumed a premium of 2 %. The phased withdrawal appears at first sight to be more like a pure investment instrument than a retirement income stream product. Its essence is that a sum of money is invested at retirement, in a portfolio over whose composition the retiree has considerable control. Both income and capital can be drawn down to meet the retiree s needs. The drawdowns, however, are limited to a range, with both upper and lower bounds, depending on the life expectancy of the retiree when they purchases the phased withdrawal 7. The maximum drawdown factor is calculated on the basis that the individual will live his expected life span at the time of the purchase of the phased withdrawal. The minimum is 23

26 calculated on the basis that he will survive until the actuarial probability of survival from the date of purchase approximates zero. These drawdown factors apply to the account accumulation each year. In Australia, phased withdrawals are the fastest growing segment of an admittedly small retirement income product market. Inflation indexed life annuities. Even a modest inflation rate of 5 % will halve purchasing power in 14 years. Combined with 3% wage productivity growth, purchasing power relative to community standards will halve in 9 years. For a retiree with a life expectancy of 15 or more years, erosion of purchasing power through inflation is thus a significant risk. For women, the risk is even greater. Escalated annuities partially address this problem. But they do not offer insurance against unanticipated inflation, which perhaps more than anticipated inflation creep, is the larger danger to annuitant welfare, precisely because of its unpredictability. It has been possible to purchase annuities indexed to the Consumer Price Index (CPI), that is, CPI indexed annuities, in Australia and the UK, for some time, and more recently, in the US. A point to bear in mind in comparing nominal with CPI indexed annuities is that the price of CPI indexed products is likely to be much more stable over time than the price of nominal annuities, because the real interest rate is less volatile than the nominal rate. Chart 1 shows both fixed and CPI indexed life annuity quotes in Australia from 1986 to 1993, a period of changing inflationary expectations 8. The chart clearly shows the relative instability of the fixed annuity quotes over this period. 7 The drawdown factors are the same for male and female annuitants. 8 The fixed life annuity is calculated with an annual fixed rate of escalation of 3%. 24

27 Chart 1: Annuity rate variability in Australia, Annuities for males aged $ Feb-86 Feb-87 Feb-88 Feb-89 Feb-90 Feb-91 Feb-92 Feb-93 Fixed Life Annuities CPI Indexed Life Annuities 6. Calculating mandatory annuity payout streams We calculate the income flows which different annuity types yield using variants of standard actuarial formulae. The generic formula for the actuarially fair annuity payment for a standard life annuity is given by: y = K / ω t t= 1 p x ( ) ( t s ) t ( 1 + r) (1) where K is the purchase price of the annuity t p is the annuitant s probability of survival t periods from age x, s is the escalation factor, r is the risk free rate of return, and ω is set at the maximum potential life span, measured from the annuitant s age, given by x, at t = 0. A nominal life annuity with no escalation is calculated using (1), but setting s = 0. 9 Life expectancy term certain annuity payouts are calculated using the same formula, with ω set equal to life expectancy, and t p set equal to unity for all t. x x 9 For simplicity, in these formulae, and in equations 3a and 4, we ignore the time subscripts on rates of return. 25

28 A variable annuity is written on the basis of an assumed investment return (the AIR). Payouts, however, are adjusted by the relationship between the performance of the underlying portfolio given by m R and the AIR. The formula is: y t m = 1+ R y t 1 1+ AIR (2) where y 0 (not actually paid) is determined according to equation (1), with r set equal to the value of AIR, and s=0. The payout stream specification for a phased withdrawal can be formalised by specifying the account accumulation at time t: K t m ( R ) yt = Kt (3a) The payout at time t of a phased withdrawal may be written: K F t 1 1 t 1 y t K F t 1 2 t 1 (3b) where 1 F t is the minimum drawdown factor, and 2 F t is the maximum. Specification of the income flows for annuities providing CPI protection is more complicated. Formica and Kingston (1991) discuss this in detail, and provide the following formula for the payout in year t: y t ω = K / t= 1 t p x ( ) ( t 1 1 s ) t ( 1+ R) + A ( t) (4) where A(t), representing the cost of the inflation insurance, is calculated from the Black- Scholes option pricing formula. 26