ANNUITY MARKETS: ANNUITY MARKETS: THE CHALLENGE OF INFLATIONTHE CHALLENGE OF INFLATION

Dimitri VittasDimitri Vittas

ConsultantConsultant

The World BankThe World Bank

FIXED NOMINAL ANNUITIESFIXED NOMINAL ANNUITIES

The main rationale for life annuities is to protect retirees from outliving The main rationale for life annuities is to protect retirees from outliving their savings. Fixed nominal annuities provide protection against the their savings. Fixed nominal annuities provide protection against the longevity and investment risks but are exposed to inflation risk.longevity and investment risks but are exposed to inflation risk.

Even a low rate of inflation of 1% per year will lower the real value of Even a low rate of inflation of 1% per year will lower the real value of annuity payments by 18% after 20 years. With 3% inflation, the annuity payments by 18% after 20 years. With 3% inflation, the reduction amounts to 45% and with 5% to 62%.reduction amounts to 45% and with 5% to 62%.

The average life expectancy of retirees is between 15 and 20 years. This The average life expectancy of retirees is between 15 and 20 years. This implies that between one half and one third of retired workers will still implies that between one half and one third of retired workers will still be alive 20 years after retirement. They will suffer heavily even with be alive 20 years after retirement. They will suffer heavily even with moderate inflation if they buy fixed nominal annuities.moderate inflation if they buy fixed nominal annuities.

Fixed nominal annuities fail to provide effective protection. Fixed nominal annuities fail to provide effective protection. Nevertheless, workers who have a short life expectancy or who Nevertheless, workers who have a short life expectancy or who underestimate their longevity prefer fixed nominal annuities because underestimate their longevity prefer fixed nominal annuities because early payments are higher than with alternative annuity products.early payments are higher than with alternative annuity products.

INFLATION AND INFLATION AND THE DECLINE IN REAL VALUESTHE DECLINE IN REAL VALUES

Rate\YearsRate\Years 1010 2020 3030

10%10% 61%61% 85%85% 94%94%

5%5% 39%39% 62%62% 77%77%

3%3% 26%26% 45%45% 59%59%

1%1% 9%9% 18%18% 26%26%

0.5%0.5% 5%5% 9%9% 14%14%

DEALING WITH INFLATION RISKDEALING WITH INFLATION RISK

Four broad types of annuity products address the inflation risk:Four broad types of annuity products address the inflation risk:

– escalating nominal annuities;escalating nominal annuities;

– fixed real annuities;fixed real annuities;

– ““dollarized” or “euroized” annuities; anddollarized” or “euroized” annuities; and

– variable annuities.variable annuities.

ESCALATIING NOMINAL ANNUITIESESCALATIING NOMINAL ANNUITIES

Escalating nominal annuities provide partial protection against inflation Escalating nominal annuities provide partial protection against inflation risk. This depends on the rate of escalation (which is usually set at 3 or 5 risk. This depends on the rate of escalation (which is usually set at 3 or 5 percent) and the inflation rate.percent) and the inflation rate.

If the rate of escalation is higher than the rate of inflation, the real value If the rate of escalation is higher than the rate of inflation, the real value of annuity payments increases. In contrast, escalating nominal annuities of annuity payments increases. In contrast, escalating nominal annuities suffer a decline in real value when the rate of inflation exceeds the rate suffer a decline in real value when the rate of inflation exceeds the rate of escalation.of escalation.

In principle, escalating annuities should appeal to people with longer life In principle, escalating annuities should appeal to people with longer life expectancy. This creates a selection bias which providers of annuities expectancy. This creates a selection bias which providers of annuities must take into account in their pricing and reserving policies.must take into account in their pricing and reserving policies.

Despite their attractions and simplicity, escalating annuities have not Despite their attractions and simplicity, escalating annuities have not been actively promoted and do not seem to play a significant part in any been actively promoted and do not seem to play a significant part in any national annuity market. national annuity market.

FIXED REAL ANNUITIESFIXED REAL ANNUITIES

Fixed real annuities provide protection against longevity, investment Fixed real annuities provide protection against longevity, investment and inflation risks.and inflation risks.

They start with lower payments than nominal annuities but exceed They start with lower payments than nominal annuities but exceed nominal annuity payments in later years. For this reason, they appeal to nominal annuity payments in later years. For this reason, they appeal to people with longer life expectancies.people with longer life expectancies.

This self-selection bias explains in part the higher load charge that fixed This self-selection bias explains in part the higher load charge that fixed real annuities entail.real annuities entail.

In the absence of inflation-linked securities, annuity providers also In the absence of inflation-linked securities, annuity providers also charge an inflation risk premium that raises their cost.charge an inflation risk premium that raises their cost.

SHORTCOMINGS OF SHORTCOMINGS OF FIXED REAL ANNUITIESFIXED REAL ANNUITIES

The main disadvantage of fixed real annuities is their high cost relative The main disadvantage of fixed real annuities is their high cost relative to nominal and variable annuities. to nominal and variable annuities.

In most advanced countries, inflation-protected securities earn on In most advanced countries, inflation-protected securities earn on average lower real rates of return than nominal securities, corporate average lower real rates of return than nominal securities, corporate equities and real estate, although their returns suffer from lower equities and real estate, although their returns suffer from lower volatility. volatility.

A second major shortcoming is that insurance companies and pension A second major shortcoming is that insurance companies and pension funds assume the inflation risk. They need to have access to inflation-funds assume the inflation risk. They need to have access to inflation-protected securities to be able to hedge their risks.protected securities to be able to hedge their risks.

FIXED REAL ANNUITIES: FIXED REAL ANNUITIES: THE CASE OF CHILETHE CASE OF CHILE

Chile does not authorize the use of fixed nominal annuities. For Chile does not authorize the use of fixed nominal annuities. For retirees who annuitize, it mandates the use of either fixed real retirees who annuitize, it mandates the use of either fixed real annuities or variable annuities.annuities or variable annuities.

In 2008, 66% of all primary pensioners had an annuity and 34% used In 2008, 66% of all primary pensioners had an annuity and 34% used a phased withdrawal. 90% of early retirees opted for a life annuity, a phased withdrawal. 90% of early retirees opted for a life annuity, but only 36% of old age pensioners. but only 36% of old age pensioners.

There was a slowdown in recent years in the growth of the annuity There was a slowdown in recent years in the growth of the annuity market because of stricter conditions for early retirement. 20,000 new market because of stricter conditions for early retirement. 20,000 new policies are issued each year, down from close to 30,000 before 2004, policies are issued each year, down from close to 30,000 before 2004, for a total premium of 50 million UFs.for a total premium of 50 million UFs.

Variable annuities were authorized in 2004, in combination with fixed Variable annuities were authorized in 2004, in combination with fixed real annuities, but there has been little activity.real annuities, but there has been little activity.

FIXED REAL ANNUITIES: FIXED REAL ANNUITIES: THE CASE OF CHILE IITHE CASE OF CHILE II

In Chile there is ample supply of medium- to long-term inflation In Chile there is ample supply of medium- to long-term inflation instruments, including government, corporate and mortgage bonds. instruments, including government, corporate and mortgage bonds. However, inflation bonds with maturities of over 20 years are not However, inflation bonds with maturities of over 20 years are not widely available. widely available.

Thus, annuity providers suffer from a duration mismatch between Thus, annuity providers suffer from a duration mismatch between their assets and liabilities. This is estimated at around 4 years.their assets and liabilities. This is estimated at around 4 years.

A new electronic quotation system was introduced in 2004 to A new electronic quotation system was introduced in 2004 to improve the marketing of annuities and lower costs. Annuity improve the marketing of annuities and lower costs. Annuity commissions have fallen to 1.5%. They exceeded 6% in the 1990s.commissions have fallen to 1.5%. They exceeded 6% in the 1990s.

FIXED REAL ANNUITIES: FIXED REAL ANNUITIES: THE CASE OF CHILE IIITHE CASE OF CHILE III

Annuitants appear to be getting a good deal, although declining real Annuitants appear to be getting a good deal, although declining real interest rates have caused a significant fall in annuity conversion interest rates have caused a significant fall in annuity conversion factors.factors.

The Money’s Worth Ratio (MWR) for joint life annuities was The Money’s Worth Ratio (MWR) for joint life annuities was calculated at 108% in March 2005, using the government bond calculated at 108% in March 2005, using the government bond yield curve. This fell to 89% when the corporate bond yield was yield curve. This fell to 89% when the corporate bond yield was used.used.

The true level of the MWR is probably in between. The The true level of the MWR is probably in between. The corresponding MWRs for the UK were estimated at 88% and 78% corresponding MWRs for the UK were estimated at 88% and 78% respectively.respectively.

REAL YIELDS ON TIPS IN US & CHILE REAL YIELDS ON TIPS IN US & CHILE ANNUITY RATES & ACFs IN CHILEANNUITY RATES & ACFs IN CHILE

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1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

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Chile

ANR

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REAL YIELDS ON TIPS IN US & CHILE REAL YIELDS ON TIPS IN US & CHILE ANNUITY RATES & ACFs IN CHILEANNUITY RATES & ACFs IN CHILE

USREAL % REAL % ANR ACF

1999 3.95 6.51 5.52 8.282000 4.15 6.38 5.58 8.232001 3.47 5.27 5.45 8.132002 3.25 4.11 5.11 7.942003 2.14 3.93 4.23 7.312004 1.95 3.51 3.33 6.752005 1.77 2.55 3.30 6.402006 2.26 2.98 3.55 6.422007 2.56 2.90 3.27 6.202008 1.51 3.24 3.59 6.29

CHILE

REAL INTERST RATES ANDREAL INTERST RATES AND ANNUITY CONVERSION FACTORS ANNUITY CONVERSION FACTORS

Rate\Years 15 20 25

5% 9.6% 8.0% 7.1%

3% 8.2% 6.7% 5.7%

1.5% 7.5% 5.8% 4.8%

0% 6.7% 5.0% 4.0%

ROLE OF INFLATION BONDS: ROLE OF INFLATION BONDS: MOST OTHER COUNTRIESMOST OTHER COUNTRIES

In most other countries, the main provider of inflation bonds is the In most other countries, the main provider of inflation bonds is the government.government.

The supply of such bonds has increased in recent years, but even so it The supply of such bonds has increased in recent years, but even so it would be wholly inadequate if the demand for fixed real annuities were would be wholly inadequate if the demand for fixed real annuities were to take off in other countries as it has done in Chile.to take off in other countries as it has done in Chile.

Thus, in addition to being expensive, inflation bonds are also in short Thus, in addition to being expensive, inflation bonds are also in short supply.supply.

Getting the government to issue more of these bonds would imply heavy Getting the government to issue more of these bonds would imply heavy reliance on the government for ensuring that the private pension system reliance on the government for ensuring that the private pension system delivers on its promises.delivers on its promises.

““DOLLARIZED” ORDOLLARIZED” OR“EUROIZED” ANNUITIES“EUROIZED” ANNUITIES

These are annuities that are linked to a stronger and more stable foreign These are annuities that are linked to a stronger and more stable foreign currency, like the US dollar or the euro.currency, like the US dollar or the euro.

They protect against runaway inflation and large currency depreciation They protect against runaway inflation and large currency depreciation in small, poorly managed, economies.in small, poorly managed, economies.

But unless they are linked to inflation-protected instruments they fail to But unless they are linked to inflation-protected instruments they fail to provide effective protection, especially over the long run.provide effective protection, especially over the long run.

US inflation averaged more than 3% per year over the past 30 years. US inflation averaged more than 3% per year over the past 30 years.

VARIABLE ANNUITIESVARIABLE ANNUITIES

The main attraction of variable annuities is that they enable retirees to The main attraction of variable annuities is that they enable retirees to participate in the normally higher investment returns of equities, real estate and participate in the normally higher investment returns of equities, real estate and commodities.commodities.

Their main weakness is that pensioners assume the investment and inflation Their main weakness is that pensioners assume the investment and inflation risks.risks.

With variable annuities, annuitants also usually share in the longevity risk. This With variable annuities, annuitants also usually share in the longevity risk. This is not a disadvantage but a different way of coping with this risk.is not a disadvantage but a different way of coping with this risk.

Variable annuities require a robust system of regulation and supervision and a Variable annuities require a robust system of regulation and supervision and a high level of transparency and integrity on the part of annuity providers.high level of transparency and integrity on the part of annuity providers.

TYPES OF VARIABLE ANNUITIESTYPES OF VARIABLE ANNUITIES

Variable annuities take two main forms: profit participating; and unit-linked.Variable annuities take two main forms: profit participating; and unit-linked.

The first type allows for some smoothing of returns. They often take the form of The first type allows for some smoothing of returns. They often take the form of “guarantee and bonus” annuities, combining guaranteed minimum benefits with “guarantee and bonus” annuities, combining guaranteed minimum benefits with annual bonuses that target the preservation of the real value of annuity annual bonuses that target the preservation of the real value of annuity payments.payments.

In unit-linked annuities, the investment risk is borne by annuitants. They are In unit-linked annuities, the investment risk is borne by annuitants. They are often offered with caps and floors on their returns which lower their exposure to often offered with caps and floors on their returns which lower their exposure to the high volatility of equity returns.the high volatility of equity returns.

Unit-linked annuities are more transparent than profit-participating annuities.Unit-linked annuities are more transparent than profit-participating annuities.

THE REGULATION THE REGULATION OF VARIABLE ANNUITIESOF VARIABLE ANNUITIES

Variable annuities require a sophisticated system of regulation and Variable annuities require a sophisticated system of regulation and supervision.supervision.

Clear rules should be adopted for the initial calculation of annuity Clear rules should be adopted for the initial calculation of annuity payments and their annual adjustment in the light of net investment payments and their annual adjustment in the light of net investment returns, inflation, longevity experience, and operating costs.returns, inflation, longevity experience, and operating costs.

The rules should specify the principles that would need to be observed The rules should specify the principles that would need to be observed in the creation of sound reserves and the distribution of profits between in the creation of sound reserves and the distribution of profits between policyholders (annuitants) and shareholders.policyholders (annuitants) and shareholders.

THE MARKETINGTHE MARKETINGOF VARIABLE ANNUITIESOF VARIABLE ANNUITIES

The marketing of variable annuities would also need to be tightly The marketing of variable annuities would also need to be tightly regulated to prevent mis-selling and other deceptive practices.regulated to prevent mis-selling and other deceptive practices.

A central register comparing and publicizing the performance of A central register comparing and publicizing the performance of different providers on a consistent and meaningful basis should be different providers on a consistent and meaningful basis should be established.established.

The example of Chile in setting up a centralized electronic quotation The example of Chile in setting up a centralized electronic quotation system would merit detailed consideration. This lowers search costs, system would merit detailed consideration. This lowers search costs, minimizes the influence of brokers, and promotes greater transparency minimizes the influence of brokers, and promotes greater transparency and competition.and competition.

The same entity could combine the two tasks of centralizing quotations The same entity could combine the two tasks of centralizing quotations and comparing performance.and comparing performance.

VARIABLE ANNUITIES VARIABLE ANNUITIES IN DENMARK AND SWEDENIN DENMARK AND SWEDEN

Variable annuities of the “guarantee and bonus” type are widely used in Variable annuities of the “guarantee and bonus” type are widely used in Denmark and Sweden. Recent years have seen significant growth in Denmark and Sweden. Recent years have seen significant growth in unit-linked annuities with some guarantees.unit-linked annuities with some guarantees.

The regulation and supervision of variable annuities appears to be robust The regulation and supervision of variable annuities appears to be robust in these two countries. It is in principle based on transparency, adequate in these two countries. It is in principle based on transparency, adequate reserving and strong competition among providers.reserving and strong competition among providers.

A major part of the market is based on collective labor agreements, A major part of the market is based on collective labor agreements, which favor defined-contribution plans and encourage the use of which favor defined-contribution plans and encourage the use of variable annuities, including both life and term annuities.variable annuities, including both life and term annuities.

Involvement of two large state entities, ATP in Denmark and PPM in Involvement of two large state entities, ATP in Denmark and PPM in Sweden, is having an impact on the market.Sweden, is having an impact on the market.

However, there is no readily accessible compilation of data on the However, there is no readily accessible compilation of data on the performance of variable annuities. performance of variable annuities.

CONCLUDING REMARKSCONCLUDING REMARKS

Most annuity products suffer from important shortcomings.Most annuity products suffer from important shortcomings.

Some are exposed to investment and inflation risk, others only to Some are exposed to investment and inflation risk, others only to inflation risk, others to fixed low returns.inflation risk, others to fixed low returns.

All annuity products suffer from liquidity risk, while fixed products are All annuity products suffer from liquidity risk, while fixed products are also exposed to annuitization risk.also exposed to annuitization risk.

The best way to handle all these risks is to promote a combination of The best way to handle all these risks is to promote a combination of payout options.payout options.

COMBINATIONCOMBINATIONOF PAYOUT OPTIONSOF PAYOUT OPTIONS

The combination of payout options should require the use of a minimum The combination of payout options should require the use of a minimum level of fixed real annuities. In many countries, this would be provided level of fixed real annuities. In many countries, this would be provided by the first pillar. In Chile, this is equal to the Minimum Pension by the first pillar. In Chile, this is equal to the Minimum Pension Guarantee.Guarantee.

For additional levels of annuitization, retirees should be free to choose For additional levels of annuitization, retirees should be free to choose between fixed real annuities, escalating, annuities, variable annuities, between fixed real annuities, escalating, annuities, variable annuities, phased withdrawals and even self-annuitization.phased withdrawals and even self-annuitization.

Lump sums and self-annuitization could play a significant part, provided Lump sums and self-annuitization could play a significant part, provided retirees are also required to purchase deferred annuities that would retirees are also required to purchase deferred annuities that would generate in older age an adequate supplement to the income from the generate in older age an adequate supplement to the income from the first annuityfirst annuity..

FIXED NOMINAL ANNUITIES SHOULD BE BANNED!FIXED NOMINAL ANNUITIES SHOULD BE BANNED!