Developments in Pension and Annuity Markets Ian Tonks
Outline Pensions policy and annuity markets in an ageing world DC pensions: auto-enrolment in UK from 2012 Structure of annuity markets in UK Types of annuities available Regulatory framework, number of providers Factors affecting price of annuities Longevity risk Interest rates Efficiency of annuity pricing: Do consumers get their money s worth? Recent developments in UK pensions policy Abolition of compulsory annuitization in UK from 2015 Big experiment! Outlook for annuity markets in Brazil
Demographics: increasing life expectancy old-age dependency Source: United Nations: World Population Prospects from http://esa.un.org/wpp/
Move to DC pension Schemes International demographic trends: ageing population, falling birth rate, declining support ratio; sustainability of PAYG state pensions? Policy response to demographic trends is to shift burden of pension provision to individuals DC pensions Although some countries (Canada, Brazil, France) have remained loyal to PAYG systems International phenomenon: World Bank (1994), EU (DG ECFIN, 2001, 2006; 2009) Two Central Questions: How much will fund be worth at retirement (risks to individual) Cannon & Tonks (2013): Journal of Risk & Insurance How to access funds at retirement
Pension Reforms: Individual DC accounts All OECD countries have some individual DCs US (401K plans); UK (personal & stakeholder pensions); NEST from 2012 Germany (Reister plans); Australia (Superannuation Guarantee) New Zealand (Kiwi saver) Recent EU members: Bulgaria, Estonia, Latvia, Lithuania, Hungary, Poland, Slovakia have shifted previous public pillar to mandatory funded private pillar Chile, Colombia, Chile, Peru, Argentina, Uruguay, Mexico, Bolivia and El Salvador all have individual DC schemes Notional DC s in Sweden & Italy Some countries have retained PAYG model but with reduced promised benefits/higher contributions: Canada, Brazil, France, Belgium, Czech Republic and Slovenia. Matijascic and Kay, ISSR, 2014
Auto-enrolment in UK Quasi-compulsory workplace national DC pension scheme in UK from October 2012 for all employees Pensions Commission (2005) Behavioural aspects: Nudge Targets 11m employees without 2 nd /3 rd tier pension provision Steady-state by 2017 contributions 8% of earnings Alternative pension providers NEST; People s Pension; Now Pensions Limited choice of low fee tracker investments After two years drop out rates 9% By 2030 the value of assets in private sector workplace pension schemes could be 1,200 n/ billion
Choices for Decumulation Phase Three ways of accessing accumulated DC pension funds at retirement a) Lump sum no restriction on usage: But moral hazard: double dipping b) Phased Withdrawals annual limits c) Annuitization: purchase of life annuity income stream for life Distinction between an annuity and a phased withdrawal is that annuity provides longevity insurance phased withdrawals do not Annuities provided by life insurers who sell to a large number of annuitants diversify away the individual s longevity risk
Longevity Risk: American Civil War
Last American Civil War Widows In 1880s a number of US states introduced war pensions for soldiers injured in the Civil War: they were still paying out these pensions into the 21st century! Maudie Celia Hopkins of Arkansas (93-years-old when died in 2008) was last surviving civil war widow. Hopkins married 86-year-old William Cantrell on Feb. 2, 1934, when she was 19. Cantrell, who served in the Virginia Infantry, supported her with his Confederate pension of $25 every two or three months until his death in 1937 Downside risk to annuity provider that liability is very longterm Of course the annuitant (consumer) was the beneficiary in this case
Shifts in the distribution represent cohort longevity risk UK Female Mortality at 60: Difference between Idiosyncratic and Cohort Longevity
Structure of UK Annuity Markets Largest in the world! Compulsory & voluntary markets Types of annuities: Level (flat rate) Joint (last survivor) Real annuities or Escalating (3 or 5%) annuity payments linked to inflation index (7% of market in 2013) Guarantees (5 or 10 year annuity payments to estate) Investment-linked (variable) annuities (invested in equities) Impaired-life/enhanced 28% of market in 2013 Annuities provided by life insurance companies: 14 providers with 3 main suppliers: Prudential, Aviva, L&G Average size of fund annuitised: mean = 35K; median 20K Regulated by Financial Conducts Authority & Prudential Regulatory Authority
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Partial relaxation of Comp Full relaxation of Comp million Annuity demand in the UK 16.000 14.000 12.000 10.000 Pension Annuities Income Drawdown Bulk Buyouts Voluntary (PLA) Around 400,000 policies in 2012 8.000 6.000 4.000 2.000 0 Year
Stock Market Reaction
Pricing annuities How does an annuity provider (insurance company) price of annuity? Annuity price (premium) is discounted sum of expected future annuity payments + mark-up. Factors affecting price: Prevailing term structure of interest rates at time of annuity purchase Information available to the life insurer about the life expectancy of the annuitant Size of the premium paid for the annuity Type of annuity purchased Post-code (House price proxy for wealth) Mark-up paid to the life insurer to cover its costs and profits Innovation in 2008
Aug-94 Aug-95 Aug-96 Aug-97 Aug-98 Aug-99 Aug-00 Aug-01 Aug-02 Aug-03 Aug-04 Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11 Comparison of annuity rates and 14% 12% 10% bond yields Male Level No Guarantee 65 Nominal ten-year government bond yield Nominal ten-year commercial (bank) bond yield Male RPI-linked No Guarantee 65 Real ten-year government bond yield 8% 6% 4% 2% 0% -2%
Life Expectancy Annuity price dependent on age and gender Selection effects in annuity markets Active: adverse selection Passive: annuity purchase correlated indirectly with life expectancy (ie wealth) Enhanced annuity rates for terminally ill Growth of this market affects rates in non-impaired market Selection effects less significant in compulsory market Life expectancy for 65 year olds keeps increasing
Changing male mortality assumptions of life insurers Industry averages Company specific
Using data on average annuity rates across providers1994-2012 Evidence on Money s worths: different types of annuity MW level =0.89 MW real = 0.80 t- test on paired diff = 3.84**
Issues facing annuity markets Partial abolition of compulsion in 2011 Full abolition of compulsion from April 2015 Very popular Guidance guarantee/advice Consumer transparency Open-market option Selection effects in voluntary market may require full medical (costly) Net effect on annuity demand unclear, because of shift to DC pensions Unintended consequences? Why are annuities unpopular with consumers? Bequests But people without children don t like them either Unfairly priced: Inflexible Will supply factors constrain growth? Number of suppliers, Longevity Risk, Regulation, Asset-liability mis-match
Consumer Guidance/Transparency If no annuitization: what is optimal decumulation strategy for individual? Highly complex, depends on: Anticipated investment returns & longevity prognosis Drivers e.g. bequests, long-term care provisions Attitude to risk, behavioural finance & costs Deferral to annuitize but optimal to annuitise around age 80 for males Drawdown may be best if risk aversion low or desire to bequeath But growth in asset exposure needed to offset mortality drag Drawdown my be operationally costly for pension provider Cognitive problems of elderly: FSA (2006) survey of financial capability found over-70s performed worst of all age groups Dementia risk doubles every five years after age 60 Financial Advice/Mis-selling? 21
Outlook for Brazil How to kick-start a small annuity market? Simple product for producers Though complicated for consumers Life data Number of providers: competition Assets to match liabilities Regulatory framework to ensure trust Compulsion? Tax incentives Nudge/framing effects
Caveat: most annuity purchases in compulsory market are voluntary!!! 30% 25% 20% 15% 10% 5% 0% 2010 2012 2014 25%-30% 20%-25% 15%-20% 10%-15% 5%-10% 0%-5% UK Annuity purchases by age with compulsion at age 75 23
Conclusions: Outlook Two effects on long-term outlook for annuity markets: Growth of DC pensions Abolition of compulsion Existing annuity markets functions satisfactorily: No abuse of monopoly power Annuity providers have been able to satisfy demand Number of annuity providers is small, so cohort longevity risk is being borne by a small number of providers. Is this sustainable? Who can bear cohort longevity risk? a) individual investors who would hold mortality bonds in a diversified portfolio, b) government, by issuing longevity bonds; or c) annuity holders themselves: annuity payments conditional on cohort survival rates Annuity providers better able to minimise the risks of an asset-liability mis-match by Availability of more longer-term government bonds Availability of index-linked bonds