1. The Role of Annuities in Public Retirement Systems Jeffrey R. Brown Presentation to World Bank May 3, 2002

2. 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?

3. Individuals are living longer Many nations witnessed dramatic advances in life expectancy over past century Expected years remaining at age 65 (US) MenWomen 190011.3 12.0 200016.4 19.6

4. But Uncertainty Remains Fraction of 65 year olds dying by age 70 Men1/8 Women1/13 Fraction of 65 year olds living to age 90+ Men1/6 Women1/3

5. Why Does Uncertainty Matter? Retirement financial planning difficult Trade-off two risks Longevity 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

6. 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

7. 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”)

13. Economic Theory Life-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

14. Why Are Annuities Valuable? Public Policy Avoids old-age poverty Prevents moral hazard in the presence of means-tested anti-poverty programs

15. 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

16. 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

17. Why are Markets so Small? Some (Less?) Likely Reasons Actuarially Unfavorable Pricing Bequest Motives Inflation Risk with Nominal Annuities Relative Returns on Alternative Investments

18. Key Policy Question: Should Individuals be Required to Annuitize Part of their Retirement Wealth?

19. Mandating Annuities: Benefits Enhance annuity market efficiency Eliminate selection effects  increase payouts In U.S., a 10% increase is upper bound Provides life-long income Reduce risk of old age poverty Reduce dependence on social assistance

20. 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

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

22. 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

23. Final Thoughts on Redistribution With uniform pricing, the trade-off between insurance and redistribution is unavoidable Significant risk-based pricing is infeasible in many countries Could offset distributional effects in other ways (contributions, tax rules) In a utility based model, these issues are of much less concern!

24. 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

25. U.S. Social Security Commission Would 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.

26. 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