W W W. W A T S O N W Y A T T. C O M Paying Out Pensions A Review of International Annuities Markets Mike Orszag

References Paper by Mirko Cardinale, Alec Findlater and Mike Orszag WW annuities website: James/Vittas study INPRS websites – – (Research Network)

Outline Review of key problems in annuities markets UK System Annuities in 12 other countries: Australia, Belgium, Brazil, France, Germany, Ireland, Italy,Netherlands, Portugal, Singapore, Spain, Switzerland

Issues Definitions of annuities vary by country: – US variable annuities as well as life insurance products in countries such as Japan with annuity payouts Size of market often quite small – Biggest life insurance companies in Italy pay no more than 1,500-2,000 annuities per year.

Annuities Problems Demand is too low (people do not protect themselves against longevity risk unless forced to). Supply is too high… but too low to meet what demand will be (suppliers do not use prudent assumptions but even so will not be able to replace state guarantees).

Annuities Problems – 6Ps Perceptions – poor value for money Processes – lack of advice Products – lack of suitable products Politics – pensions used for non-pensions purposes Parameters – lack of data to price annuities and unrealistic assumptions Portfolios – lack of risk management by insurers, sometimes due to regulatory issues or lack of supply of matching instruments.

Life Expectancy (Unisex) Source: UN Population Data (2001)

Effective Retirement Ages Source: Latullippe( 1996)

Duration of Retirement (Years) Source: Latullippe(1996)

The annuity premium Though yield is low, annuities yield more for retiree than underlying non- annuitised investments in the same instruments.

Drawdown: An Alternative Fund starts out at age 65 Consumption = Fund/Life expectancy Consumption growth = return on fund – mortality rate

The Problem

UK Retirement Income Basic state pension Optional second state pension – contracted out benefits must be annuitised on single-sex, joint life basis with unisex tables DB pensions – payments as index linked benefits (lump sum related to final salary) DC pensions – annuitised before age 75 (option of drawdown before age 75) (lump sum of 25%)

Source: Merrill Lynch and Prudential/M&G (Simon Pilcher) Market size (£ billion) Growth of the Corporate Bond Market

Index Linked Yields AustraliaCanadaFranceSwedenUKUSA Real yield (% pa) Source: Barclays Capital

Annuities in the UK New business volumes in the UK annuities market (Source: Association of British Insurers)

Annuity Categories (plus Drawdown) Level annuities Escalating annuities Index linked annuities With profits annuities Investment linked annuities Income drawdown Flexible annuities

Annuities Products in the UK 2001 New UK Annuity Business by Volume (Source: Association of British Insurers)

Annuities Products in the UK 2001 New Internal Annuity Business by Volume (Source: Association of British Insurers)

Annuities Products in the UK 2001 New External Annuity Business by Volume (Source: Association of British Insurers)

Perceptions “It must be a scandal to be forced to hand over forever one’s hard-saved capital to an insurance company, which will pay a return, while you are alive, of currently less than a third of what it will earn on it. Why is the government so generous to insurance companies and extortionate to those who have saved for retirement” - A.M. Scriven (letter to newspaper quoted by Oonagh McDonald in “Income in Retirement: Are Annuities the Answer?”)

Perceptions Belief of bad value for money: Insurers exploit monopoly to to charge consumers more Government Policy of Mandatory Annuitisation

Value for money of annuities Internal rate of return on annuities Nov. 26, 1999

The Annuity Margin Term structure Market Annuity Rate Mortality Assumptions The Annuity Margin The annuity margin is the difference between the term structure and the implied term structure. Interpretation is margin as function of assets under management

The Annuity Margin

Australia No compulsion but tax incentives because of means tested benefits Superannuation system – 80%-90% paid as lump sums. Virtually no life annuities market – under US$100m Allocated annuities (A$4.5bn), relatively concentrated market Significant term market (A$2bn) – terms up to 20 years

Belgium Replacement ratios from state system around 50%. Roughly 40% covered by private sector DB plans. Occupational pensions pay out lump sum, term of life annuities. Lump sum has tax advantages – after 1985 occupational plans switched to paying out lump sums. Most plans are profit sharing of interest and mortality, fixed annuities uncommon.

Brazil Occupational sector with R$171bn in assets Occupational pensions pay annuities which are indexed linked. Some plans offer partial lump sums. Personal pensions – participating annuities with index-linked guarantees. New VGBL product combines life insurance with annuity payment on retirement.

France Loi Madelin plans for self-employed – must be annuitised Low penetration of traditional products. Most products offer investment-risk sharing New products: unit-linked, guarantees.

Germany Occupational pensions – most payments are in terms of annuities. Most private products are deferred with-profit products. Riester reforms of 2001 – annuitisation required eventually, 20% of capital may be taken as lump sum.

Ireland Occupational DB pensions – annuitised except for lump sum (British model) Personal pensions – after 1999, lump sum after guaranteed pension of Euros. Income drawdown fund as alternative until age 75. Nonprofit annuities most common. With profit and impaired life annuities still available.

Italy 50% mandatory annuitisation of new second pillar funds (1993 law). Tax incentives for further annuitisation. Single premium annuities rare in Italy. Most common annuities offer investment profit sharing – mortality profit sharing not allowed. Virtually no market for fixed nominal annuities Life insurance annuity options common but rarely exercised.

Netherlands 85% of workers covered by occupational pensions. Compulsory annuitisation for both occupational pensions and third pillar arrangements. Deferred annuities quite common for DC occupational arrangements 2/3 of market for personal pension annuities is with profits, 1/3 unit linked.

Portugal 2/3 of occupational and many personal pension funds must be annuitised. Coverage of occupational plans low – 3.6% of workforce. Profit sharing annuities prevalent. No unit-linked or index-linked annuities.

Singapore Minimum Sum Scheme Flat rate annuities prevalent About 20% of population buys annuities. Lack of long duration securities poses problems

Spain No compulsory annuitisation Low coverage of occupational schemes. Higher coverage of voluntary schemes but contributions are low – assets of third pillar only 25bn Euros. DB occupational plans typically taken as annuities. Bulk annuities common. Some advantage for low income individuals to buy annuities from DC plans. Non-profit annuities.

Switzerland Annuitisation normally required for mandatory occupational pensions. Majority of voluntary arrangements paid as lump sums. Bulk contracts common – optional index-linking. Voluntary annuities – capital guarantees.

Summing Up Different annuities models: – Continental European (with profits with technical interest rate) – British (non-profit annuities) Both models have significant problems.

Annuities Problems – 6Ps Perceptions – poor value for money Processes – lack of advice Products – lack of suitable products Politics – pensions used for non-pensions purposes Parameters – lack of data to price annuities and unrealistic assumptions Portfolios – lack of risk management by insurers, sometimes due to regulatory issues or lack of supply of matching instruments.