Defined Contribution Plans, Mortality Risk, and the Demand for Annuities
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Transcript of Defined Contribution Plans, Mortality Risk, and the Demand for Annuities
Defined Contribution Plans, Defined Contribution Plans, Mortality Risk, and the Demand Mortality Risk, and the Demand
for Annuities for Annuities
James PoterbaJames PoterbaMIT and NBERMIT and NBER
Longevity 5 Conference, September 2009 Longevity 5 Conference, September 2009
OutlineOutline
Shifting Composition of Retirement Shifting Composition of Retirement Saving: Rise of Defined Contribution Plans Saving: Rise of Defined Contribution Plans
Current Patterns of Payouts and Annuity Current Patterns of Payouts and Annuity Demand in Self-Directed DC Plans Demand in Self-Directed DC Plans
Implications of DC Plan Growth for the Implications of DC Plan Growth for the Demand for Longevity Insurance Demand for Longevity Insurance
U.S. Private Retirement System: U.S. Private Retirement System: Shift from DB to DC Shift from DB to DC
1980: Roughly 75% of Pension Contributions in 1980: Roughly 75% of Pension Contributions in the U.S. to Defined Benefit Plansthe U.S. to Defined Benefit Plans
2005: 73% of Pension Contributions to Defined 2005: 73% of Pension Contributions to Defined Contribution (401(k), 403(b)) Style PlansContribution (401(k), 403(b)) Style Plans
DC Plan and IRA Assets in 2006: $8.3T ($16.4T DC Plan and IRA Assets in 2006: $8.3T ($16.4T in Total Retirement Assets)in Total Retirement Assets)
Future Retirees will Have Lifetime Exposure to Future Retirees will Have Lifetime Exposure to 401(k)s401(k)s
Retirement Asset Landscape, 2006 Retirement Asset Landscape, 2006
401(k) Plans: $2.7T401(k) Plans: $2.7T
457 and 403(b) Plans: $834B 457 and 403(b) Plans: $834B
IRAs: $4.3TIRAs: $4.3T
Private DB Plans: $2.3TPrivate DB Plans: $2.3T
State/Local DB Plans: $3.0TState/Local DB Plans: $3.0T
Federal Plans: $1.1TFederal Plans: $1.1T
Private-Sector Pension Private-Sector Pension Participation Rates, 2008 Participation Rates, 2008
Full-Time Workers:Full-Time Workers:– 24% in Defined Benefit Plans24% in Defined Benefit Plans– 51% in Defined Contribution Plans51% in Defined Contribution Plans– 60% in Some Pension Plan60% in Some Pension Plan
Part-Time Workers: Part-Time Workers: – 10% in Defined Benefit Plans10% in Defined Benefit Plans– 18% in Defined Contribution Plans18% in Defined Contribution Plans– 23% in Some Pension Plan 23% in Some Pension Plan
401(k) Eligibility & Participation 401(k) Eligibility & Participation Rates, 1984-2003 SIPPRates, 1984-2003 SIPP
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10
20
30
40
50
60
70
1984 1987 1991 1993 1995 1998 2003
401(k) Participation
401(k) Eligibility
Cohort Patterns of 401(k) Cohort Patterns of 401(k) Participation Participation
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10
20
30
40
50
60
70
25 30 35 40 45 50 55 60
Age
Part
icip
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C15
C20
C25
C30
C35
C40
C45
C50
C55
C60
401(k) Balances Among 401(k) 401(k) Balances Among 401(k) ParticipantsParticipantsAverageAverage MedianMedian
19991999 $66,660$66,660 $24,844$24,844
20032003 80,59280,592 43,12743,127
20072007 137,430137,430 76,94676,946
Accumulation Potential in 401(k)s Accumulation Potential in 401(k)s (Purcell 2007)(Purcell 2007)
Married Couple Contributing 8% of Salary Married Couple Contributing 8% of Salary for 30 Yearsfor 30 Years
Historical Returns (pre-2008) on EquitiesHistorical Returns (pre-2008) on Equities
Median Balance at 65 for Median Earner: Median Balance at 65 for Median Earner: $468,000$468,000
2525thth Percentile Earner: $289,000; 75 Percentile Earner: $289,000; 75thth Percentile $706,000 Percentile $706,000
Median Replacement Rates for Median Replacement Rates for 401(k)-Participating Retirees, 2035 401(k)-Participating Retirees, 2035
(Holden & VanDerhei, 2005)(Holden & VanDerhei, 2005)
Income QuartileIncome Quartile Social SecuritySocial Security 401(k) Plan401(k) Plan
LowestLowest 52%52% 51%51%
SecondSecond 3131 5454
ThirdThird 2323 5959
HighestHighest 1616 6767
Ratio of Projected Defined Ratio of Projected Defined Contribution Plan Assets to Defined Contribution Plan Assets to Defined
Benefit Plan Liabilities Benefit Plan Liabilities
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0.5
1
1.5
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2.5
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3.5
4
2000 2010 2020 2030 2040
Recent Events and DC Recent Events and DC Accumulation Profile Accumulation Profile
401(k)s Lost $500B Between June 30 and 401(k)s Lost $500B Between June 30 and December 31, 2008December 31, 2008Employer Cutbacks in 401(k) GenerosityEmployer Cutbacks in 401(k) GenerosityRegulatory Swing Away from DC Model – But to Regulatory Swing Away from DC Model – But to What? What? Open Issues: Incentives for Expansion of Open Issues: Incentives for Expansion of Pension Coverage, “Auto-Enrollment,” Pension Coverage, “Auto-Enrollment,” Government-Funded Plans for Low Income Government-Funded Plans for Low Income Households Households
The New Focus: Drawing Down The New Focus: Drawing Down Assets in Retirement Assets in Retirement
Search for Simple Rules: X% Per Year? Search for Simple Rules: X% Per Year? Simple Rules May Be Dominated Simple Rules May Be Dominated
With Uncertain Longevity, No Bequest With Uncertain Longevity, No Bequest Motives or Medical Spending Shocks, Motives or Medical Spending Shocks, Individuals Should Fully Annuitize Individuals Should Fully Annuitize
More Complex Analysis: Potential Medical More Complex Analysis: Potential Medical and Nursing Home Costs, Bequest and Nursing Home Costs, Bequest Motives – Annuity Demand is ReducedMotives – Annuity Demand is Reduced
Longevity Risk is a Key Factor in Longevity Risk is a Key Factor in Translating Assets into Lifetime Translating Assets into Lifetime
Income Security Income Security Conditional on Age 65, Probability of Dying by 75 is 0.254 for Men, 0.189 for Women
Conditional on Age 65, Probability of Living to 90 is 0.181 for Men, 0.275 for Women
Dispersion of Longevity Outcomes Dispersion of Longevity Outcomes for Married 65-Year-Old Couple for Married 65-Year-Old Couple 38.4 Expected Remaining Person-Life-Years
13.5 Expected Years Together
Expected Years Lived by Widowed Wife: 6.8
Expected Years Lived by Widower: 4.5
First Death: 25% Chance by Age 73, 50% by Age 78
Second Death: 50% Chance After Age 90, 25% After Age 93
Prob(Wife Survives Husband) = 57.5%
Factors the Influence Annuity Factors the Influence Annuity Demand Demand
Understanding of Mortality RiskUnderstanding of Mortality Risk
Employer Provision of Annuity Options to Employer Provision of Annuity Options to Employees in DC PlansEmployees in DC Plans
The Cost of AnnuitiesThe Cost of Annuities
Demand for Late-Life Liquid AssetsDemand for Late-Life Liquid Assets– Bequest MotivesBequest Motives– Concerns Related to Medical CostsConcerns Related to Medical Costs
Mortality Perceptions Mortality Perceptions
Hurd / McGarry Compare Subjective Hurd / McGarry Compare Subjective Mortality Probabilities in Health and Mortality Probabilities in Health and Retirement Survey with Actual Mortality Retirement Survey with Actual Mortality RatesRates
Men: Survey Average Survival Probability Men: Survey Average Survival Probability to Age 75: 0.622. “Actual” from Mortality to Age 75: 0.622. “Actual” from Mortality Table: 0.594. Women: 0.663 and 0.746.Table: 0.594. Women: 0.663 and 0.746.
Survival to 85: Subjective 0.388 for Men Survival to 85: Subjective 0.388 for Men (0.242 “actual”), 0.460 (0.438) for Women (0.242 “actual”), 0.460 (0.438) for Women
Life Expectancy for 65-year-old Life Expectancy for 65-year-old Males, by Birth Cohort Males, by Birth Cohort
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5
10
15
20
25
1912 1917 1922 1927 1932 1937 1941
Top 50%
Bottom 50%
What Do DC Plan Participants What Do DC Plan Participants Choose? Choose?
DB Plan Evidence (Mottola/Utkus): Active DB Plan Evidence (Mottola/Utkus): Active De-Annuitization and Lump Sum Demand De-Annuitization and Lump Sum Demand ICI Study 1995-2000 Period: Only 23% of ICI Study 1995-2000 Period: Only 23% of DC Plan Participants with Choice at DC Plan Participants with Choice at Retirement Chose AnnuityRetirement Chose AnnuityOregon Public Employees Study Oregon Public Employees Study (Chalmers/Reuter) – Poor Health, Strong (Chalmers/Reuter) – Poor Health, Strong Recent Stock Market Returns Reduce Recent Stock Market Returns Reduce Annuity DemandAnnuity Demand
Annuity Choices of TIAA-CREF Annuity Choices of TIAA-CREF Participants, 1989-2001Participants, 1989-2001
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20
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60
1989 1991 1993 1995 1997 1999 2001
1-Life Annuity
Joint Annuity
Non-Annuity
Payout Options in Large Defined Payout Options in Large Defined Contribution Plans, 2000 NCS Contribution Plans, 2000 NCS
Only 38% of 401(k) Plans, 33% of All Only 38% of 401(k) Plans, 33% of All Defined Contribution Plans Defined Contribution Plans OfferOffer an an Annuity Option Annuity Option
Lump-Sum Distribution is the ONLY Lump-Sum Distribution is the ONLY Option in 28% of 401(k) Plans, 30% of All Option in 28% of 401(k) Plans, 30% of All DC PlansDC Plans
Why?Why?
Offering Annuities Imposes Offering Annuities Imposes Fiduciary Liabilities on Employers Fiduciary Liabilities on Employers
Annuitizing Annuitizing withinwithin DC Plan: Employer Must DC Plan: Employer Must Select Annuity ProviderSelect Annuity Provider
Long-Term Financial Health Difficult to Long-Term Financial Health Difficult to Gauge, Risk of Subsequent Lawsuit by Gauge, Risk of Subsequent Lawsuit by EmployeesEmployees
Annuity Options Available to Annuity Options Available to Individuals Individuals
Sales of New Single-Premium Immediate Sales of New Single-Premium Immediate Annuities: $12.8 Billion in 2007 Annuities: $12.8 Billion in 2007
Variable Annuity Market is Much Larger Variable Annuity Market is Much Larger but Very Few Assets are Annuitized but Very Few Assets are Annuitized
2007 SCF: 9.5% of Households Aged 75-2007 SCF: 9.5% of Households Aged 75-84 Report Receiving Income from 84 Report Receiving Income from AnnuitiesAnnuities
Annuitized Income Streams Approximately Annuitized Income Streams Approximately Half of Income for 65-74 Year Olds Half of Income for 65-74 Year Olds
Explaining Small Private Annuity Explaining Small Private Annuity Markets Markets
““DEMAND:” Precautionary Demand for DEMAND:” Precautionary Demand for Liquid Wealth, Bequest Motives, Informal Liquid Wealth, Bequest Motives, Informal Longevity Insurance Provided within Longevity Insurance Provided within FamiliesFamilies
““SUPPLY:” Unattractive Annuity Prices SUPPLY:” Unattractive Annuity Prices Because of Adverse Selection or Limited Because of Adverse Selection or Limited CompetitionCompetition
Expected Present Discounted Expected Present Discounted Value (EPDV) of Annuity Payouts Value (EPDV) of Annuity Payouts
per Premium Dollar per Premium Dollar
EPDVEPDVNOMNOM = = ΣΣt=1,Tt=1,TSStt*A*ANOMNOM/{/{ΠΠj=1,tj=1,t(1+i(1+ijj)})}
Survival Rates – Population Life Table or Survival Rates – Population Life Table or Annuitant Life Table, Projected Forward Annuitant Life Table, Projected Forward
Choice of Bonds for Discount Rates – Choice of Bonds for Discount Rates – Riskless Treasuries vs. Risky Corporates Riskless Treasuries vs. Risky Corporates
EPDV Does Not Recognize Insurance EPDV Does Not Recognize Insurance Value of Annuity to IndividualValue of Annuity to Individual
Money’s Worth of Individual Money’s Worth of Individual Annuities, May 2009 Annuities, May 2009
Annuitant Annuitant Mortality TableMortality Table
Population Population Mortality TableMortality Table
Interest Interest Rate:Rate:
Cor-Cor-porateporate
TreasuryTreasury Cor-Cor-porateporate
TreasuryTreasury
Men Age 65Men Age 65 0.8180.818 1.0541.054 0.7510.751 0.9460.946
Women Age Women Age 6565
0.8330.833 1.1031.103 0.7480.748 0.9600.960
Why Are EPDV Values < 1? Why Are EPDV Values < 1?
Insurance Company Administrative Costs Insurance Company Administrative Costs or Profitsor Profits
Adverse Selection: Annuitant Population is Adverse Selection: Annuitant Population is Longer-Lived Than Population at LargeLonger-Lived Than Population at Large
Risk Premium to Cover Cost of Future Risk Premium to Cover Cost of Future Mortality Improvement Mortality Improvement
Adverse Selection: Comparing Adverse Selection: Comparing Mortality Rates for Annuitants & Mortality Rates for Annuitants &
Population at Large, 2007 Population at Large, 2007
Annuitant MortalityAnnuitant Mortality Population MortalityPopulation Mortality
MenMen WomenWomen MenMen WomenWomen
6565 1.02%1.02% 0.57%0.57% 1.72%1.72% 1.16%1.16%
7575 2.982.98 1.611.61 4.294.29 2.982.98
8585 8.068.06 5.085.08 11.3511.35 8.548.54
Evidence of Adverse Selection: UK Evidence of Adverse Selection: UK Compulsory Annuity Market Compulsory Annuity Market
Nominal AnnuityNominal Annuity
Inflation-Indexed Annuity Inflation-Indexed Annuity
““Escalating” Annuity (3% per year)Escalating” Annuity (3% per year)
Nominal Annuity: For 65 year old males, Nominal Annuity: For 65 year old males, 41% of EPDV is in First Five Years, 6% 41% of EPDV is in First Five Years, 6% Beyond Age 85; Contrast with 34% (9%) Beyond Age 85; Contrast with 34% (9%) for a Policy with 3%/Year Escalation (US for a Policy with 3%/Year Escalation (US 2008 Corporate Discounting)2008 Corporate Discounting)
Five-Year Survival Probability, 61-Five-Year Survival Probability, 61-65 Year Old Male Annuitant 65 Year Old Male Annuitant
(Finkelstein-Poterba)(Finkelstein-Poterba)Compulsory Compulsory AnnuityAnnuity
Voluntary Voluntary AnnuityAnnuity
Nominal Nominal 0.9130.913 0.9510.951
EscalatingEscalating 0.9700.970 0.9890.989
GuaranteedGuaranteed 0.9110.911 0.9400.940
Index-LinkedIndex-Linked 0.9620.962 0.9800.980
A Key Concern: Late Life Medical A Key Concern: Late Life Medical CostsCosts
CBO Projection for Cohort Turning 65 in CBO Projection for Cohort Turning 65 in 20102010
Any Nursing Home Use: 45%Any Nursing Home Use: 45%
One Year or Longer in a Nursing Home: One Year or Longer in a Nursing Home: 25%25%
Average Nursing Home Costs: $187/day Average Nursing Home Costs: $187/day for Semi-Private Room, $209/day for for Semi-Private Room, $209/day for Private Room Private Room
How Large is the Risk Premium for How Large is the Risk Premium for Aggregate Mortality Risk? Aggregate Mortality Risk?
Forecasting Mortality is Difficult Forecasting Mortality is Difficult
Risk of Medical Breakthrough Could Risk of Medical Breakthrough Could Change ExperienceChange Experience
Life Insurers are Affected by Illness Life Insurers are Affected by Illness Shocks (1918 Influenza, AIDS) Shocks (1918 Influenza, AIDS)
How Does Correlation with Other How Does Correlation with Other Aggregate Shocks Affect Risk Charges?Aggregate Shocks Affect Risk Charges?
Share of Annuity EPDV From Share of Annuity EPDV From Payouts in First Five Years (2009) Payouts in First Five Years (2009)
AnnuitantAnnuitant PopulationPopulation
Interest Interest RateRate
CorporateCorporate TreasuryTreasury CorporateCorporate TreasuryTreasury
Men, 65Men, 65 0.4020.402 0.3350.335 0.4310.431 0.3670.367
Women, Women, 6565
0.3720.372 0.3010.301 0.4070.407 0.3410.341
Annual Mortality Improvement RateAnnual Mortality Improvement Rate
1950-1950-19801980
1980-1980-20072007
1950-1950-20072007
Men, 65-74Men, 65-74 -0.53%-0.53% -1.61%-1.61% -1.05%-1.05%
Men, 75-84 Men, 75-84 -0.58-0.58 -0.99-0.99 -0.78-0.78
Men, 85+Men, 85+ -0.56-0.56 0.290.29 -0.14-0.14
Women, 65-74Women, 65-74 -1.61-1.61 -0.49-0.49 -1.07-1.07
Women, 75-84Women, 75-84 -1.57-1.57 -0.35-0.35 -0.98-0.98
Women, 85+ Women, 85+ -1.09-1.09 0.290.29 -0.42-0.42
Lee-Carter Mortality Model and Lee-Carter Mortality Model and Monte Carlo Results on EPDVs Monte Carlo Results on EPDVs
ln mln ma,ta,t = = ααaa + + aa*k*ktt + + εεa,t a,t with mwith ma,ta,t = crude death = crude death
rate at age a in year t rate at age a in year t
qqa,ta,t = mortality rate, age a, year t = 1 – exp[- m = mortality rate, age a, year t = 1 – exp[- ma,ta,t]]
Aggregate Mortality Factor kAggregate Mortality Factor k tt Follows a Random Follows a Random
Walk with DriftWalk with Drift
Estimate for {Estimate for {ααaa, , a , a , kktt} for Men over 1950-2007 } for Men over 1950-2007
Period (a = 65, …, 110) Period (a = 65, …, 110)
Stochastic Simulation of Future Paths of Stochastic Simulation of Future Paths of Mortality Rates Can be Used to Compute EPDV Mortality Rates Can be Used to Compute EPDV of Annuitiesof Annuities
Potential Variation in EPDV of Potential Variation in EPDV of Annuity for 65-Year-Old Men, 2009 Annuity for 65-Year-Old Men, 2009
Valuation Valuation PercentilePercentile
Treasury Yield Treasury Yield Discount Rate Discount Rate
Corporate Yield Corporate Yield Discount RateDiscount Rate
1010thth 0.8920.892 0.7170.717
2525thth 0.9140.914 0.7310.731
MedianMedian 0.9380.938 0.7450.745
7575thth 0.9610.961 0.7610.761
9090thth 0.9820.982 0.7730.773
Implications of Continued Growth of Implications of Continued Growth of Self-Directed DC Plans Self-Directed DC Plans
Absent Compulsory Annuitization (UK Absent Compulsory Annuitization (UK Model), Individuals Will Make Decisiosn Model), Individuals Will Make Decisiosn About Annuitization About Annuitization
Marketing Longevity Insurance Products to Marketing Longevity Insurance Products to Institutions Alone (Plan Managers, Institutions Alone (Plan Managers, Pension Fiduciaries) Will Not Penetrate Pension Fiduciaries) Will Not Penetrate DC UniverseDC Universe
Longevity Risk Facing Insurers is Only Longevity Risk Facing Insurers is Only One Factor Depressing Annuity Volume One Factor Depressing Annuity Volume