Annuities Markets and Policy Issues in Reformed Social Security Systems

1. Annuities Markets and Policy Issues in Reformed Social Security Systems by Estelle James

2. Why are annuity markets important? • Annuities market small, little known in most countries--but will grow as social security systems are reformed to include individual accounts • In old system, defined benefits provide lifetime pension; in new system funds accumulate in a defined contribution plan • How are these accumulations turned into a lifetime income stream? • Most countries have dealt with first stage of pension reform—accumulation. But second stage --payouts, is equally important.

3. Annuities have an important role to play in payout stage • Each person’s lifetime is uncertain so he may run out of money before death—defeats purpose of social security system • Annuities take large premium and turn it into income stream until death--provide longevity and often investment insurance • If expected lifetime is higher, monthly payout is lower • Some annuity products add other added protections and costs

4. Voluntary annuity markets are small because: • Myopia and lack of understanding • Annuitization increases some risks since savings are irreversibly committed: People want flexibility for emergencies, bequest for family if die early • Crowd-out by social security benefits, employer pensions, family system • Adverse selection--people who expect long lifetimes buy annuities, make price too high for those with lower lifetimes

5. Annuities in reformed social security systems • • But annuity market will grow if mandatory social security changes—less DB, more funds, form of payouts restricted. • • I will discuss key policy and regulatory issues and give results from one study that measures cost-effectiveness of annuity markets in several countries

6. Policy issues regarding payouts when social security is reformed • 1. Should annuitization be mandatory or voluntary? What other payout forms should be used? • 2. What types of annuities are possible and what types should be allowed? Should joint annuity, price-indexed annuity be required? Should variable annuities be allowed? • 3. What are the permissable categories for risk categorization?

7. Policy issues (Cont’d) • 4. How cost-effective is annuity provision by insurance companies? • 5. Should specialized or general purpose insurance companies be used? • 6. Should retail or group market be used? • 7. Should price be controlled? • 8. What information should be disclosed? • 9. Other regulatory issues • 10. What steps must be taken to prepare for annuity markets?

8. 1. Should annuitization of Pillar 2 savings be mandatory or voluntary? • Rationale for mandatory retirement savings is that people are myopic, may not save enough for their old age and may live in poverty or become charge on public treasury • Myopia may still exist at age 65, although perhaps not as much. Therefore important to make sure they don’t spend all their retirement savings too quickly. Limits on speed of withdrawal important.

9. Dilemma: Pillar 2 savings are person’s “property” but restrictions turn it into “tax” • Many legitimate reasons for not wanting to turn entire savings into fixed income stream • Solution: Make sure each person annuitizes enough to keep him/her out of poverty • Large Pillar 1 allows more discretion re Pillar 2 • Savings beyond threshold can be more discretionary--e.g. gradual withdrawals

10. What do countries with mandatory savings do? • Annuitization is mandatory in Sweden, most Eastern and Central European countries • But they may find this impossible for first 10-15 years—accumulations too small, insurance companies unreliable • Mandatory beyond age 75 in UK and 5 years after retirement in Argentina (new) • Gradual withdrawals permitted in Australia, most of Latin America--may lead to moral hazard problem if Pillar 1 is means-tested

11. 2.What forms of annuities are available, which should be permitted? • SPIA--single premium immediate annuity: you pay today and annuity begins. Simplest form. • Deferred annuity--you pay today but annuity begins 5-10 years later; allows gradual purchase • Annuity with10 or 15 year guarantee--your estate collects even if you die. Good for unhealthy and those who want to leave bequests. Monthly amount less but expected lifetime amount similar. • Joint annuity--after your death specified beneficiary (spouse?) collects some %. Supports dependents, prevents poverty among old women.

12. Annuity types (Cont’d) • Nominal v. price-indexed annuity that keeps up with inflation. Latter maintains real purchasing power, but insurance companies charge for this--can’t hedge against inflation. • Should government issue indexed bonds? • Should companies provide partial indexation? • Shouldn’t require unless government matches with long term indexed bonds or sets caps. • Each extra protection costs, reduces monthly payout; policy-maker must consider trade-offs.

13. Canada US Aus-tralia UK-nominal UK-price indexed Chile-price-indexed Level SPIA 740 733 700 727 522 820 10YG 702 658 691 761 Joint SPIA 664 648 543 642 438 731 Escalating SPIA 564 Monthly payout for immediate annuity, man age 65, 100,000 premium, 1999

14. Fixed v. variable annuities? • Fixed annuity gives fixed income stream, like investment at government bond rate. Insurance company bears risk. But payout depends on bond rate on date of annuitization--retirement date risk. Gradual purchase over several years may be preferred. • Variable annuity varies with investment return and/or cohort longevity. Payout increases when market return rises. Investment risk increases but retirement date risk falls.

15. What do countries do? • Switzerland, Chile--joint annuity (60% to survivor). • Chile, Hungary, Mexico--indexed annuity.UK--indexed up to 5% annual inflation. Costs. Not clear if Hungary & Mexico can provide indexed annuities and how much they will cost • Singapore--nominal, 10-15 year guarantee, no joint annuity. Variable annuities popular • Argentina--joint, nominal, variable with 4% annual return as floor • Were costs v. benefits carefully thought out? Limitation on product form helps consumers compare price, but must choose forms carefully

16. 3. What are allowable risk categories? • If every one is charged the same price, this becomes good deal for people who who expect to live long and bad deal for unhealthy people, leads to redistribution, adverse selection, creaming. • Insurance companies learn how to put people into different risk categories and charge lower prices for people expected to die young--gender, age, etc. Avoids adverse selection and creaming. • But price differentiation causes other problem.

17. Risk categories for annuities • Gender a key predictor but may lead to lower pensions & poverty for older women • Race, income, job, health, family history, DNA could predict longevity, different payouts • This may benefit vulnerable groups (poor, uneducated, sick), who die young, subsidize better-off groups if in single pool. If differentiated they get better terms, buy more. • But differentiation may violate social norms, privacy. Which categories should be allowed? • If no differentiation, probably should use single provider and mandatory annuitization.

18. What do countries do? • Can income, gender, race, DNA. etc. be used? Varies by country’s norms. • Gender-specific tables used in Chile, Hong Kong, Australia, Switzerland Pillar 3 (voluntary). • Unisex tables required in Hungary, Poland(?), UK, Switzerland Pillar 2 (mandatory). This redistributes, may lead to creaming, but keeps older women out of poverty. • With joint annuities, unisex issue less important • In UK special rates for health impaired. • Low earners don’t get better terms—admin costs • As annuity markets grow, information about and use of risk differentiation will grow, if allowed.

19. 4. How effectively do insurance companies provide annuities? • One measure: compare premiums paid with total lifetime payouts--money’s worth ratio (MWR) • discount future payouts to get present value • reduce by probability that you die, don’t collect • this gives EPDV--expected present discounted value of annuity • MWR = EPDV/initial premium paid in. Annuity is good for consumers if MWR=100% --get back premium+longevity insurance

20. Key assumptions and methodological difficulties • Discount rate—risky rate or risk-free rate? • Portfolios are risky but reserves, regulations, negative correlation with other insurance products, sometimes government guarantees • Use term structure but future returns unknown (reinvestment risk few long term bonds) • Mortality tables • No up-to-date mortality tables, use UK’s or US • Mortality improvement for future cohorts uncertain • Three longevity groups-annuitants, covered workers, entire populations

21. Calculations of MWR in several countries • Payouts vary widely across countries due to interest rate differences, but MWR vary less • I calculated MWR using government bonds rate as discount rate, country mortality tables, two longevity groups--annuitants (high longevity) and population (average) • MWR for annuitants 95-100%, even>100% • Average annuitant gets government bond rate + longevity insurance • Lower MWR for average population member, risky discount rate and price-indexed annuities.

22. Canada US Australia UK-nominal UK-P indexed Chile-P indexed Popu-lation Annui-tant Annui-tant Annuitant Annuitant Annuitant Annuitant Individ-ual 91.4 98.1 99.5 101.3 97.7 88.7 99.5 Joint 93.9 98.0 97.0 98.8 98.7 88.0 101.3 MWR for men, age 65, 1999 (based on common mortality improvement factor)

23. How do insurance companies cover their costs if MWR=100%? • They invest premium in mixed portfolio--public & private bonds, mortgages, small amount of equities • They earn risky rate, pay annuitants risk- free rate: cover their costs and profits out of spread (1-2%) between two rates • Risk to annuitant is reduced by: • investment diversification, hedging, negatively correlated risks among insurance products, reinsurance and guarantee funds, company stockholders bear losses, bankruptcy laws protect annuitants • some government guarantees

24. So annuity market works well • For annuitant who wants fixed income stream and is satisfied with risk-free rate • Doesn’t work well for worker who knows he is sick, prefers flexible income for emergencies, wants indexed annuity, or is willing to accept greater risk for greater return--these groups keep demand low • Also doesn’t work well if insurance companies don’t have good investment options or are unsafe--so careful regulation needed

25. 5. Specialized or general purpose insurance companies? • Specialized organizations easier to monitor, requires asset segregation, prevents hidden cross-subsidization to or from annuitants • But limit benefits from negatively correlated risks (life v. annuities), cost more • In most countries general purpose companies used and assets not segregated—economies of scale and scope but regulation difficult.

26. 6. Group annuities v. retail market • Retail--individual and insurance company seek eachother out, market sets price • In group market, system negotiates group price with limited number of companies and products (competitive bidding)--reduces choice and marketing costs • So far most reforming countries use retail market although those built on employer-sponsored plans may use group market • Sweden uses public agency with single community pool (public control over assets)

27. 7. Are price controls desirable? • Regulator might choose wrong price and won’t change price with interest rates; better to let market set, although group contract may be preferable • Switzerland sets annuity conversion factor at 7.2% of retirement savings for joint annuity--losses for companies since interest rate and mortality rate have fallen. Changes now underway

28. 8. Information • Important to distribute price information to consumers to enable comparisons. Aided by product standardization, internet. • Singapore--Every 6 months Central Provident Fund collects price and product information and distributes. Has one of lowest costs, highest values. • Chile—now requires electronic quotes • Argentina has much variety, no transparency, difficult to compare costs and values

29. 9. Good regulation essential but difficult: • Cohort mortality tables for population don’t exist • Annuitants are select group with higher longevity--little data and selection changes as policies change • Future mortality improvements unknown; likely to be high due to catch-up in developing countries • Long term financial instruments unavailable so difficult to match assets to liabilities • Future interest rates unknown, reinvestment risk high • Future inflation unpredictable and indexed bonds unavailable; price-indexed annuities not credible • Companies may expand now, problems show up later

30. 10. Steps to take now • Long planning horizon is necessary • Fill in gaps in financial instruments, collect data for mortality tables, build regulatory expertise--takes many years • Many trade-offs, must be thought through carefully--especially important if funded DC pension plan is adopted but also important for other countries