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2 Annuity and inflation The main rationale for life annuities is to protect retirees from outliving their savings. Fixed nominal annuities provide protection against the 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 annuity payments by 18% after 20 years. With 3% inflation, the reduction amounts to 45% and with 5% to 62%. 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 be alive 20 years after retirement. They will suffer heavily even with moderate inflation if they buy fixed nominal annuities. Fixed nominal annuities fail to provide effective protection. Nevertheless, workers who have a short life expectancy or who underestimate their longevity prefer fixed nominal annuities because early payments are higher than with alternative annuity products.

3 Annuity and inflation Rate\Years %61%85%94% 5%39%62%77% 3%26%45%59% 1%9%18%26%

4 Four broad types of annuity products address the inflation risk: escalating nominal annuities; fixed real annuities; “dollarized” or “euroized” annuities; and variable annuities.

5 escalating nominal annuities Escalating nominal annuities provide partial protection against inflation risk. This depends on the rate of escalation (which is usually set at 3 or 5 percent) and the inflation rate. If the rate of escalation is higher than the rate of inflation, the real value of annuity payments increases. In contrast, escalating nominal annuities suffer a decline in real value when the rate of inflation exceeds the rate of escalation. In principle, escalating annuities should appeal to people with longer life expectancy. This creates a selection bias which providers of annuities must take into account in their pricing and reserving policies. Despite their attractions and simplicity, escalating annuities have not been actively promoted and do not seem to play a significant part in any national annuity market.

6 fixed real annuities Fixed real annuities provide protection against longevity, investment and inflation risks. They start with lower payments than nominal annuities but exceed nominal annuity payments in later years. For this reason, they appeal to people with longer life expectancies. This self-selection bias explains in part the higher load charge that fixed real annuities entail. In the absence of inflation-linked securities, annuity providers also charge an inflation risk premium that raises their cost.

7 fixed real annuities The main disadvantage of fixed real annuities is their high cost relative to nominal and variable annuities. In most advanced countries, inflation-protected securities earn on average lower real rates of return than nominal securities, corporate equities and real estate, although their returns suffer from lower volatility. A second major shortcoming is that insurance companies and pension funds assume the inflation risk. They need to have access to inflation-protected securities to be able to hedge their risks.

8 “dollarized” or “euroized” annuities These are annuities that are linked to a stronger and more stable foreign currency, like the US dollar or the euro. They protect against runaway inflation and large currency depreciation in small, poorly managed, economies. But unless they are linked to inflation-protected instruments they fail to provide effective protection, especially over the long run. US inflation averaged more than 3% per year over the past 30 years.

9 variable annuities The main attraction of variable annuities is that they enable retirees to participate in the normally higher investment returns of equities, real estate and commodities Their main weakness is that pensioners assume the investment and inflation risks. 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. Variable annuities require a robust system of regulation and supervision and a high level of transparency and integrity on the part of annuity providers.

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