The Economics of Annuities

Transcription

1 The Geneva Papers on Risk and Insurance Vol. 29 No. 1 (January 2004) The Economics of Annuities by Richard Taylor 1. Introduction The challenges of an ageing global population are among the most pressing on the public policy agenda. However, in looking at issues around retirement income, the emphasis has largely been on the accumulation phase: saving for retirement. So far, rather less attention has been paid to the decumulation phase: turning the pot of savings into an income stream. However, as more and more people approach retirement, this becomes the key issue for them. There are potentially significant risks for the consumer in converting savings into income, the most pressing being to ensure they do not outlive their savings. Insurance companies therefore have a key role to play in this, in providing annuities. An annuity is a product which is designed to give the purchaser, the annuitant, an income for life, however long or short that is. It is the only financial contract that provides an income for life. Thus, for a single payment, it insures the purchaser against outliving his assets. However, the opportunities presented by this market are not without their risks. This article will begin by considering the demand for annuities, in part by looking at the U.K. experience. Last year, the Association of British Insurers carried out research into the characteristics of annuitants in the U.K. So, drawing on this, I will explore some of the drivers of demand now and in the future; what informs the decision to buy an annuity; the characteristics of annuitants in the U.K.; and what the risks are for the purchaser. Then the article will examine issues around the supply of annuities, including who provides annuities; what types of annuities there are; how they are funded; what drives profitability; and what the risks to the annuity provider are. This leads into issues of price and, in particular, whether annuities are seen as providing value for money and, indeed, how that might be measured. 2. Demand Why is there a growing interest in annuities? This is a significant world market. However, it is small in relation to the potential size, with the U.K. the largest market in the world. Nevertheless, demand is growing. This is driven by a number of factors. First, previous pension sales and the growth in associated funds will have an impact on the demand for annuities. Growth in the short to medium term should be increased by the timing of retirement of the baby boom generation over the next ten years. In the longer term, the move towards more and more Defined Contribution (DC) pension schemes and away from Defined Benefit Head of Research, Association of British Insurers. I should like to thank Julie Stark in the ABI Pensions Team, and Gary Stears and Alex Roy of the ABI Research Department for their insights and comments on earlier drafts of this paper. Published by Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK.

2 116 TAYLOR (DB) or final salary schemes, is likely to continue to push growth upwards. Moreover, as companies increasingly seek to de-couple from their own pension schemes (certainly in the U.K.), there is a further driver of demand. Thus, as countries all over the world consider how they develop their social security systems for provision of retirement income and place greater emphasis on the private sector to deliver a solution to the pensions problem, there will be a focus on how countries should deal not only with the accumulation phase of retirement income provision, but also the decumulation phase. Why should an individual want to purchase a pension annuity? After all, it is a complex product and one which requires the consumer to make an irrevocable decision with a substantial proportion of their pension savings. Both those, in themselves, act as a deterrent to demand. By definition, an annuity offers the purchaser an income for life, so the purchaser is taking out insurance against outliving the value of his assets. For the risk averse, 1 in annuity income should be worth more than 1 in cash. Without an annuity, individuals would underconsume over their lifetimes, to ensure they do not end their lives in poverty, because they cannot know for sure how long they will live. The more risk averse an individual is, the greater will the utility value of the annuity be. However, it appears that, in the absence of compulsion, the world annuities market is likely to remain smaller than it should be. And the U.K. s pre-eminence in the annuities market reflects the fact that purchase there is compulsory with DC pension funds. Therefore, whether demand does increase to its potential depends on policymakers. In particular, it depends on the extent to which pension annuity purchase is made compulsory. The first issue with world demand, then, is that it is likely to remain low in the absence of compulsion (Mackenzie, 2002). There may be a number of reasons why people do not want to protect themselves against longevity risk unless they are forced to. One is the perceived inflexibility of the product itself, which makes it unattractive. Some consumers think they are getting bad value for money, and others want to leave a bequest to their heirs. Money used to purchase an annuity generally cannot then be passed on in a bequest if the annuitant dies early, at least not in a straightforward manner. It is suggested, therefore, that people are reluctant to buy an annuity because they want to pass on their pension pot to their successors. Perhaps people also generally underestimate longevity risk. They may not expect to outlive their assets and do not realize the cost of doing so. Associated with that is the other important risk in the absence of compulsion: adverse selection. Without compulsion, those more likely to purchase an annuity are those more likely to live longer. But a range of issues impact on people s lifespan. In the absence of compulsion, annuity providers are pooling risks which are biased and this affects the price, and that in turn impacts on the attractiveness of the product. At the same time, the need to annuitize may be affected by the prevailing domestic social security provision. That is to say, the need for individuals to annuitize, at least in the short term, may be reduced by existing generous levels of state provision. As pressure on budgets increases, and private provision replaces public, then the policy towards annuitization will have to reflect these changing circumstances. The implications of this are that there is a strong case for requiring all or part of a person s pension savings to be used to buy an annuity. Or, at least, that purchase should be compulsory to some minimum degree. This is because it will: help ensure that people have a minimum income in retirement, rather than consuming all their assets and relying on the state;

3 THE ECONOMICS OF ANNUITIES 117 reduce the incidence of free riding; reduce adverse selection. Compulsion has the effect of increasing the size of the risk pool and facilitating the cross subsidy between those who die young and those who live long. At the same time, it may be perceived by annuitants, and policymakers, to redistribute from the poor, who tend to die earlier, to the rich, who tend to live longer. However, research by Jeffrey Brown at the University of Illinois (Brown, 2002) suggests that, while people who generally have a high income and are a low mortality risk can expect to receive more payments, those who have a lower income will value the insurance highly (because they no longer have to save for the highly improbable outcome of living to a very old age). In fact, these two things nearly balance. Although actual prices vary between groups, the annuity equivalent wealth is not widely dispersed between race, income and gender groups. If it is accepted that annuitization, up to a certain level, should indeed be compulsory, then it is important to decide what options are available for deciding on the minimum level of annuitization. It is also worth considering whether there should be any exceptions to compulsion. As a general rule, any exceptions should be kept to the very minimum. Thus, it has been suggested (Mackenzie, 2002), for instance, that the only exception should be for the terminally ill. This sounds like something worth considering, although it may be easier to propose theoretically than introduce practically. Minimizing exceptions reduces adverse selection and lowers the average life expectancy of the pool. It also reduces the risk of poverty in the very old. What options are available for setting the minimum level of annuitisation? There are probably four alternatives (Mackenzie, 2002): 1. a minimum premium value; 2. a minimum annuity payment; 3. a minimum replacement ratio; 4. some mixture of minimum annuity payment and replacement ratio. In the U.K., personal pensions can be drawn any time between the ages of 50 and 75. Up to 25 per cent can be withdrawn from the fund as a tax-free lump sum. The remainder must be used to purchase an annuity. The timing of purchase can be deferred and an individual can draw income from a pension pot through an income drawdown scheme. However, the pension pot must be turned into an annuity by the age of 75. This requirement to annuitize is unpopular with some; for instance, a Private Member s Bill has been introduced to the U.K. Parliament to try to modify the requirement to purchase an annuity. This raises questions over the way forward and how annuities might be modernized and made more relevant to the current and future needs. The U.K. is the largest market for annuities and may give some indication of the issues which will be important for other markets. In the U.K., there were over 320,000 pension annuities sold in 2002, generating 7.2 billion in new premiums. The average fund, however, was just 25,000 roughly A38,000. This is a small fund to annuitize and it has often been suggested that people had more than one fund, so that a low average figure was misleading. In fact, our research (Stark, 2002) suggests the opposite, with two-thirds of people buying just one annuity. The majority of people in the U.K. do, in fact, have relatively small amounts in their pension funds.

4 118 TAYLOR 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Less that 10,000 10,000 19,999 20,000 29,999 30,000 39,999 40,000 49,999 50,000 59,999 60,000 69,999 70,000 79,999 80,000 89,999 90,000 89, , , , , , , , , , , , , , , , , , , , , ,000 and above Figure 1: Distribution of annuity funds (2001) 2.1 U.K. consumer research To try to understand some of the characteristics of annuitants in the U.K. market, we commissioned consumer research in May 2002 and interviewed 500 people who had bought an annuity in the last three years, plus another 100 who had retired but not yet purchased an annuity. Looking at the characteristics of those who bought pension annuities, Figure 2 shows that most annuitants buy their annuities well before the age of 75, the age at which annuity purchase is mandatory in the U.K. This is probably because they cannot afford to do otherwise and therefore suggests that increasing the age 75 limit, as has been called for by a number of commentators, would not benefit very many people. Comparing the age at which people bought their annuity with the age at which they retired, Figure 3 shows that, in the U.K., over 60 per cent purchase their annuity at retirement. Again, this suggests that it is unlikely that measures aimed at allowing people to further delay annuity purchase beyond age 75 would be very relevant to most people. However, these people may be interested in measures which would allow them some flexibility to delay annuity purchase. For example, one suggestion is that people should be allowed to take the tax-free lump sum which is available in the British system without buying their annuity at the same time. This might allow those who currently are unable to afford to delay annuity purchase at all, the flexibility to do so. Figure 4 compares the personal incomes of those who purchased their annuity immediately on retirement ( immediate purchasers ) and those who delayed buying their annuity ( deferrers ). It suggests that the reason deferrers may be more able to defer annuity purchase than immediate purchasers is because they have more personal income to live on.

5 THE ECONOMICS OF ANNUITIES % Before 60 14% % % People purchase their annuities well before the age of 75 Figure 2: Characteristics of annuitants 26% 7% 5% 62% Same year Up to one year 1 to 2 years More than 3 years Over 60% purchase their annuity at retirement Figure 3: Annuity purchase and deferral The reasons cited for delaying by those who deferred annuity purchase are in Figure 5. For many (39 per cent) it was indeed because they had sufficient other income to live on. Others (13 per cent) wanted to wait and see if annuity rates improved or (9 per cent) could not take their annuity until a certain age. Eight per cent wanted to allow their capital to grow and 5 per cent preferred income drawdown or phased retirement. Very few cited advice as their reason for delaying. Although it is reassuring that most people defer because they do not yet require the annuity income, it is concerning that very few cited advice as a reason for deferring. If those who hope annuity rates will improve have not taken advice, they may not realize that annuity rates are affected by interest rates and longevity and are therefore unlikely to improve dramatically in the short term. Similarly, those who hope that their capital will grow may not realize, if they have not taken advice, just how much their capital will need to grow to compensate for the loss of the valuable annuity cross-subsidy.

6 120 TAYLOR 60% 50% 40% 30% 20% 10% 0% < ,000-4,999 5,000 + Immediate purchasers All de fe rre rs Deferrers have more monthly personal income so can afford to defer (and to retire earlier). Figure 4: Income of purchasers and deferrers Had other income - pension not needed 39% Waiting to see if rates improved / low rates at the time 13% Can't / couldn't take out until a certain age, e.g. 65, 70 9% To allow capital to grow 8% Preferred income drawdown / phased retirement 5% Advised not to (source of advice not mentioned) 1% Inheritance reasons 1% Waiting to see if Government change rules on annuities 1% Only 1% delay for inheritance reasons Figure 5: Reasons for delaying But most interesting, and perhaps surprising of all, was that only 1 per cent cited inheritance as their reason for deferring. Critics of annuities have suggested that people do not want to buy annuities because they want to be able to leave their pension fund money to their heirs. However, this finding suggests that people do not view their pension funds as lump sums accumulated for their heirs to inherit, but as funds to be turned into an income in retirement. It is important to differentiate this from the concerns which people have about receiving value for money from their annuity. The popularity of the money-back guarantee, which offers to return a portion of the capital if an annuitant dies within a specified period of purchasing the annuity, makes it clear that people are concerned about the fact that they might lose the capital they paid for the annuity if they die soon after purchase. Moving on to the numbers and types of annuity purchased, Figure 6 shows that the majority of people (almost two-thirds) only purchase one annuity. Sixteen per cent purchase two and 13 per cent purchase three.

7 THE ECONOMICS OF ANNUITIES % 60% 50% 40% 30% 20% 10% 0% Don t know Almost two-thirds purchase only one annuity. Figure 6: Number of annuities On the types of annuity purchased, the research results showed that: The most popular annuity in the U.K. is a basic single life, level annuity with no guarantee (42 per cent purchased this). Women are as likely to buy this type of annuity as men but, more worryingly, 28 per cent of females did not know which type of annuity they had bought. This points to a need for more education, information and advice about annuities. Those for whom the state pension or their annuity was their main source of income (which we looked at earlier) were more likely to purchase the basic type of annuity than others. And those with larger funds to spend were more likely to purchase indexation, guarantees and other annuities. It is worth considering what other types of annuity might comprise. They will include investment-linked annuities which provide the prospect of greater returns but at greater risk. It is logical that those with larger funds who can afford to take some risk are more likely to purchase this type of annuity. However, other will also include impaired life and enhanced annuities. These annuities are just as likely to be appropriate for those with small pension funds as for those with large funds (if not more so). As not all providers offer these types of annuities, information and advice is needed to alert the consumer to their existence. Finally, interviewees were asked how interested they would have been in the various policy options currently being considered in the U.K., had these been available at the time of purchase. The options were: more information and advice; money-back guarantees; changing their annuity provider after purchase; and changing the type of annuity after purchase. This shows that almost half (47 per cent) of respondents were interested in having the

8 122 TAYLOR 60% 50% 40% 30% 20% 10% 0% Very interested Fairly interested Not very interested Not at all interested Don t know More advice/information Changing annuity type Guarantees Changing annuity providers Almost half were interested in a money-back guarantee and 31 per cent in more information and advice Figure 7: Appetite for change option to purchase a money-back guarantee. The next most popular option, with almost onethird (31 per cent) showing an interest, was more information and advice. However, Figure 8 shows that, while over 20 per cent of those interested in a money-back guarantee would have been willing to give up 20 per cent of their income in exchange for it, few people were willing to give up much income in exchange for more advice and information about their annuity, despite the popularity of this option. This in turn suggests that a way needs to be found of making information and advice accessible to consumers at a low cost. This is a key lesson which is of relevance to the wider world market. Decisions are frequently made in the absence of advice, or with insufficient professional help. The need for low-cost, accessible advice, is central to ensuring people get access to the most suitable product for them. 2.2 Drivers of demand Two questions arise in relation to future demand. First, what is going to drive the level of demand in the future? Secondly, what types of annuity are likely to be demanded and how is this going to change over time? Clearly the demand for annuities is likely to rise because of the combination of the increase in the size of the retiring population and the growing importance of the private pensions market. However, the level and growth in demand depends on the complex interactions of a number of things, linked to social policy, individual preferences and the market. How these play out will vary from country to country. However, overall, there is likely to be a strong surge in demand as the baby boom generation retires and starts to convert its pension savings into an income stream. Moreover, given the continuing decline in conventional annuity rates, there is also likely to be some switch towards enhanced and impaired life annuities. There may also be an increased demand for price-indexed annuities, though how this will emerge may vary from market to market, depending, at least in part, on the amount of state-funded, index-linked, pension available to people. Modelling future demand is, therefore, complex, since there are a large number of

9 THE ECONOMICS OF ANNUITIES % 50% 40% 30% 20% 10% 0% 20% 10% 5% 5% More advice/information Changing annuity providers Guarantees Changing annuity providers Willing to mapy for money-back guarantee but not for more advice and information. Figure 8: Paying for change variables which need to be taken into account. The ABI commissioned some research (Watson Wyatt, 2003) to try to understand what the dynamics behind this market in the U.K. might be. The research involved drawing up three scenarios, which included assumptions about equity returns, bond yields, inflation and capital growth in the stock market. To these economic assumptions were added alternative demographic trends, including making moderate adjustments to ages at retirement and the mix of individuals at risk of retirement. These scenarios gave an assessment of the growth rate of the U.K. market. For individual annuities, the research suggested that, on the most conservative assumptions, demand would grow at 8.7 per cent a year for the next ten years. Using assumptions which include higher investment returns, the growth could be over 10 per cent a year. It is clear that this is a market where there is likely to be strong and persistent growth, even under relatively modest assumptions about the future. 3. Supply This raises important questions about the ability of the industry in the U.K., but ultimately elsewhere, to cope with the likely increase in demand. The insurance industry is the natural supplier of annuities, which after all are insurance products, insuring against living too long, and, because they provide life insurance, can exploit economies of scale and scope, increasing efficiency. The provision of life insurance and annuities both require many of the same skills and information, while annuities and life insurance are a natural hedge for one another. Nevertheless, there are a large number of challenges for the providers of annuities, particularly now as demand is set to increase substantially. What are the risks that the insurer faces?

10 124 TAYLOR Longevity risk The key risk is that the annuitants in the pool live longer than expected. However, we are aware that individuals are indeed living longer than was expected even only a few years ago. For the individual annuitant, he is purchasing an annuity to insure against longevity, that he does not outlive his assets. For the insurer, he has to ensure that he prices the annuity correctly, so that he accurately accounts for the change in longevity of the pool. If annuitants live longer than expected in the pricing, this will reduce the profitability of the product. Latest data suggest that mortality tables have consistently underestimated the life improvement of males. A particular feature of this is cohort risk. The group of people born between 1925 and 1945 have benefited from faster mortality improvements than those born in adjacent decades. This healthy generation has seen the greatest improvements in mortality, although it is not clear why. What is clear, however, is the effect this is having on annuities provision and pricing. Because insurers underpriced annuities sold to the healthy generation, the subsequent generation is being hit by a double whammy: their own improved mortality has led to lower annuity payments; however, the companies must also recoup the losses on the previous generation so prices are boosted because of that. A representation of the trade-off between longevity underestimates and investment returns is in Table 1 which shows for a given life table the additional investment return required to offset an ongoing unanticipated reduction in death rates ranging from 0.5 per cent p.a. to 2.0 per cent p.a. Table 1: Additional investment return required according to unexpected reduction in future death rates Reduction in death rates 0.5% p.a. 1.0% 1.5% p.a. 2.0% p.a. Age of annuity purchase % p.a. % p.a. % p.a. % p.a Notes: Base interest rate ¼ 4% p.a. Mortality ¼ CMIB medium cohort year of use See Appendix 8b for associated additions to life expectation. Source: Watson Wyatt Size of the risk pool In order to diversify the risk properly, the insurer needs to have a large enough pool of annuitants. This allows for the cross-subsidy between those who die early and those who live longer than expected.

11 THE ECONOMICS OF ANNUITIES 125 However, one recent feature in the U.K. has been the development of different types of annuity, particularly impaired life annuities (for people with an existing illness) and enhanced annuities (for people such as smokers, with a lifestyle which is biased against long life). Designed for people who are likely to live very much less than the average, they offer enhanced annuity values and therefore provide an opportunity for fairer annuity rates for all and reduce the opportunity for cross-subsidization. Interest rate risk The insurer needs an appropriate asset to match against his liability. The obligation is a long, potentially very long, one and so there is a need for a large, mature long-bond market. However, we know that as government borrowing is brought under greater control there is a possibility of a shortage of debt of both the quality and tenor that is required. This could force companies to use shorter dated paper, and lower quality bonds, with the associated interest rate and default risk. Provider profitability could be severely constrained and companies could themselves be compromised. Profitability The very long-term nature of annuities means that it is impossible to tell if sales to any particular cohort have in fact been profitable for a very long time. 4. Pricing A key issue in the annuities market relates to the price. In particular, in a low inflation, low-interest-rate world, the accusation is often levelled that annuities are not good value for money. It is true that annuities rates have declined along with interest rates. Annuities rates in the U.K. for a male aged 65 have declined from 18 per cent in the late 1970s to around 8 per cent now. Research by Cannon and Tonks (2002) has shown that the money s worth of an annuity, the ratio of the present value of the flow of promised payments made by an annuity to the money paid for the annuity, has, in the U.K., been insignificantly different to 1 and sometimes lies above unity. This suggests that not only are annuitants getting good value for money, they are getting better than a fair deal. This also raises questions about the ability of companies to price correctly and to make a satisfactory return on capital on this product. Even so, this might mean that falling annuities rates are having a damaging effect on pensioners welfare. However, falling interest rates are usually related to increasing capital values. As a result, the value of the fund invested is larger and this should compensate for lower annuities rates as has been the case over the last 30 years. In fact, measuring the replacement ratio (the ratio of the pension income from the annuity to labour income) these have increased over the last 30 years in the U.K., in response to the growth in pension funds as a direct result of the growth in equities markets. It also needs to be borne in mind that the value of an annuity to the individual pensioner is more than just the monetary value it generates. An individual with a fixed quantity of assets to live off in retirement would have to estimate how long he was going to live and spread them out accordingly. Because he has to allow for greater than expected longevity, the individual will underconsume, in order to avoid destitution. The annuity provides the certainty of income which removes that uncertainty.

12 126 TAYLOR Jeanne Louise Calment, the French lady who died in 1997, aged 122, provides a very good example of almost all the risks which are associated with annuities as an insurance product. Jeanne Calment was over 90 when she entered into a contract which was a form of annuity. She promised her house to her neighbour, a notary, on her death, on condition that he pay her U.S.$ 500 a month for the rest of her life. This transaction contains many of the elements of an annuity purchase and contains, or at least highlights, many of the risks, both for the purchaser and for the insurer. She had no direct heirs (her only grandson died in 1963) and so was not concerned by the bequest motive. With no liquid assets and no income she was a prime candidate for purchasing an annuity. However, because she was purchasing her annuity in the absence of compulsion, there is the risk of adverse selection. Though she was old when she entered into the transaction, she knew that she came from a long-lived family (her mother lived to the age of 89 and her father to 94) and had led a healthy life. She had already lived much longer than average. The clear expectation, on the part of the neighbour, was that she would not live very much longer and that the value of the property would be greater than the amount paid out to her. However, the neighbour had miscalculated. Mme Calment lived for around 30 years, so he bore the whole of the longevity risk and literally paid the price. Over the course of the contract, the amount paid out was significantly more than the value of the house. At the same time, because he did not have a large pool of annuitants, he could not cross-subsidize the effect of the longer life of Mme Calment. 5. Conclusions Annuities may well be the Cinderella of the pensions world, but they are rating more and more attention as the importance of private pension provision becomes clear. The research which we have undertaken into the U.K. market may point to some of the important issues which policymakers will have to consider when they look at the role of private pensions in retirement income. The problems which U.K. policymakers and providers are wrestling with now are ones which are likely to emerge in other markets around the world. There are therefore lessons to be learned. If the U.K. experience is widely shared, people will have relatively small amounts of savings to annuitize and will tend to buy level annuities which take no account of inflation. Providing for the rising demand for annuities is a key challenge for the insurance industry, not least because of the issues around pricing and around the adequacy of supporting assets. For both consumers and providers, a key issue is the assessment of longevity risk. This is a critical factor in pricing and profitability. Experience suggests that improvements in longevity are consistently underestimated. If the increasing demand for annuities is going to be profitable for providers, then this is the risk that must be accurately assessed and priced. The supply of assets looks constrained, given the trends towards government borrowing and funding. The problem is particularly acute with reference to index-linked government bonds, where demand is almost certain to outstrip supply. There may be a need for the industry, policymakers and regulators to consider the development of the market and its implications in a much more holistic way than in the past.

13 THE ECONOMICS OF ANNUITIES 127 REFERENCES BROWN, J.R. and WARSHAWSKY, M., 2000, Longevity-insured retirement distributions from pension plans: market and regulatory issues, Stanford Institute for Economic Research, discussion paper 00-05, November. BROWN, J.R., 2002, Differential Mortality and Annuity Valuation, Presentation to The Future of Annuities workshop of the Journal of Pensions Economics and Finance, November. CANNON, E. and TONKS, I., 2002, Annuities Prices, Money s Worth and Replacement Rates: UK Experience , CMPO Working Paper 02/051, September. MACKENZIE, G.A., 2002, The Role of Private Sector Annuities markets in an Individual Accounts Reform of a Public Pension Plan, IMF Working Paper WP/02/161, September. MITCHELL, O. and McCARTHY, D., 2002, Annuities for an Ageing World, National Bureau of Economic Research, Working Paper 9092, August. PONZETTO, G., 2003, Risk Aversion and the Utility of Annuities, Centre for Research on Pensions and Welfare Policy, Working Paper 31/03, July. STARK, J., 2002, Annuities the Consumer Experience, ABI Research Report, October. WATSON WYATT LLP, 2003, Pension Annuities: market dynamics and the implications for supply, ABI Research Report, September.