The Role of Annuities in Public Retirement Systems

Jeffrey R. Brown

Presentation to World Bank

May 3, 2002

The “Second Half” of Retirement Security

Many countries around the world are undergoing shifts from traditional DB to DC pension systems

Most of the debate and focus has been on accumulation issues – how much money will people have at retirement?

Equally important to retirement security is the payout phase – after retirement, how do individuals convert their wealth into a sustainable stream of retirement income?

Individuals are living longer

Many nations witnessed dramatic advances in life expectancy over past century

Expected years remaining at age 65 (US)

MenWomen

1900 11.3 12.0

2000 16.4 19.6

But Uncertainty Remains

Fraction of 65 year olds dying by age 70

Men 1/8

Women 1/13

Fraction of 65 year olds living to age 90+Men 1/6

Women 1/3

Why Does Uncertainty Matter?

Retirement financial planning difficult

Trade-off two risksLongevity Risk• The risk of outliving one’s resources

Under-Consumption Risk• The risk of dying with substantial wealth

that could have been used to finance higher consumption levels while living

How Address this Risk?

Life Annuities insure this risk

Trades a stock of wealth for an income stream that cannot be outlived

Solves the consumers retirement wealth allocation problem

Why Are Annuities Valuable?

Individual Perspective

Eliminates risk of outliving one’s resources

Provides higher level of sustainable income that is available without annuities (the “mortality premium”)

Economic TheoryLife-cycle model with mortality uncertainty and no bequest motives (Yaari 1965)Individuals should annuitize 100% of their wealth!Simulations: “How much additional wealth would one need, in the absence of annuities, to be as well off as if one had access to actuarially fair annuities?”Annuities equivalent to an increase in non-annuitized wealth of 50% or more

Why Are Annuities Valuable?

Public Policy

Avoids old-age poverty

Prevents moral hazard in the presence of means-tested anti-poverty programs

Annuity Markets Worldwide

Most annuitization occurs through defined benefit public pension schemes

Most individual annuity markets are quite small, especially relative to what theory suggests

Raises questions about payout policies in defined contribution systems

Why are Markets so Small?Some Likely Reasons

No Wealth to Annuitize

Substantial Annuitization through PAYGO Defined Benefit Systems

Families as Substitutes for Annuitization

Illiquidity / Desire for Flexibility

Lack of Understanding

Why are Markets so Small?Some (Less?) Likely Reasons

Actuarially Unfavorable Pricing

Bequest Motives

Inflation Risk with Nominal Annuities

Relative Returns on Alternative Investments

Key Policy Question:

Should Individuals be Required to Annuitize Part of

their Retirement Wealth?

Mandating Annuities: Benefits

Enhance annuity market efficiency Eliminate selection effects increase payouts

In U.S., a 10% increase is upper bound

Provides life-long incomeReduce risk of old age poverty

Reduce dependence on social assistance

Mandating Annuities: Costs

Lack of choice will over-annuitize some individuals

Individuals who know they will die young

Individuals with strong bequest motives

Possible financial redistribution from poor to rich due to mortality differences

In U.S., expected transfers up to 20% of account

Much less redistribution on a utility-adjusted basis

Thinking about RedistributionAnnuities are supposed to redistribute from short-lived to long-lived individualsNeed to think about redistribution ex ante, not ex post. Ex ante redistribution occurs when there are differences in mortality risk across sub-populationsEx: Low-income individuals have higher mortality rates than high-income individuals

Redistribution by Annuity Type

Annuities are less “regressive” when:They are front-loaded (nominal vs. real)

They have “guarantees” (if bequests valued)

The cover multiple lives

The longevity insurance is reduced when:Annuities are not inflation protected

Payouts are reduced to provide guarantees

Final Thoughts on Redistribution

With uniform pricing, the trade-off between insurance and redistribution is unavoidableSignificant risk-based pricing is infeasible in many countriesCould offset distributional effects in other ways (contributions, tax rules)In a utility based model, these issues are of much less concern!

Spousal Considerations

Often, there is more than one individual who is dependent on a given stream of retirement income

Joint-and-survivor annuities play an important role in preventing poverty among elderly widows

U.S. Social Security CommissionWould require governing board to offer several types of annuities: real, nominal, bequest options.At retirement, personal account distributions should be taken as annuities or gradual withdrawals. Allow lump-sum access for balances above a threshold.For couples, a two-thirds joint and survivor annuity is required unless both spouses agree to alternative arrangement.

Conclusions

Economic theory suggests that annuities ought to play a central role in providing a secure source of retirement income

Policy-makers must carefully weigh the trade-offs between preserving individual choice versus ensuring retirement security at least cost

One possible “rule” is to require enough annuitization to ensure that individuals stay above some minimum threshold