Payout choices in Chile: what are they are why? by Estelle James, Guillermo Martinez and Augusto Iglesias

2 Why Chile? Chile has had individual accounts for 22 years, therefore many retirees What choices do retirees make during the payout stage? How do producers respond? How do regulations influence this behavior? What problems have arisen? What can other countries learn from Chile?

3 Rules of the Game Retirees must purchase annuity from insurance company or programmed withdrawal (PW) from AFP’s according to formula set by regulator Annuity gives fixed payouts, PW payouts vary Lump sum not permitted unless pension>70% worker’s average wage Pension must be price-indexed Gender-specific mortality tables used but pension must be joint for workers with dependents (married men) Normal retirement age 65M, 6W but early retirement permitted if preconditions met

4 2 key choices that determine time stream of retirement income 1) Early versus normal retirement 2) Annuities versus programmed withdrawal (PW) –Normal retirement age is 65 for men, 60 for women, but 60% of all retirees have retired early, many before age 55 (stop contributing, start withdrawing, may continue working) –2/3 of all workers have annuitized—lifetime income, consistent with life cycle model, higher than elsewhere –Big difference between early and normal retirees: 85% of ER but only 34% of NR have annuitized –80% of annuitants are ER but 75% of PW are NR Why this disparate behavior and what are the implications for old age income & fiscal liability?

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7 Main answers Choices strongly influenced by guarantees and regulations—details of policies matter: pensioners and pension providers respond rationally Guarantees and regulations have lead –workers with small accumulations to take PW at normal retirement age, with MPG providing insurance; –workers with large accumulations to retire early, with annuities providing insurance; –insurance companies to aggressively market early retirement with annuities more than AFPs sell PW’s –Is this intrinsic demand for insurance or marketing- driven demand? Constant or falling pension with rising MPG could lead to unanticipated contingent liability for govt.

8 Minimum pension guarantee an important part of story Every worker with 20 years contributions is guaranteed pension=MPG MPG set in nominal terms but reset each year; de facto linked to wages, around 25% average wage Jumps up 9% at age 70 Reduced for early retirees Also applies to survivors benefits If accumulation isn’t large enough to purchase annuity=MPG, worker must take PW and spend down accumulation, after which govt pays pension

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10 1) PW vs. annuities Annuity: insurance company takes premium, provides level price-indexed income stream with investment and longevity insurance. No bequest. If MPG rises above annuity, govt tops up. Govt insures 75% annuity>MPG. PW: money stays in AFP, AFP doesn’t insure, worker’s account gets investment earnings, heirs inherit balance. Payout formula for PW set by regulator--like annuity formula but front-loaded due to increasing life expectancy of survivors, higher interest & mortality assumptions If PW falls below MPG, must spend down at MPG floor, after which govt pays—MPG provides insurance under PW Both involve contingent liability for govt., especially PW

11 Are annuities a good deal? Mortality tables out-dated but according to recently developed table, MWR 98% at age 65 using risk-free term structure—1999 and 2003 (less for women, younger pensioners, risky rate) Unusually high for indexed annuities—required so no adverse selection, many indexed investment instruments available. Insurance companies cover costs out of spread between risk free rate and rate they earn on more diversified portfolio—around 1.4%

12 Monthly payout MWR- RV98, period MWR- RV98, cohortized MWR- RV85- regulator Age 65, SPIA Age 55, SPIA Joint (65/60/60%) Age 65, SPIA, risky rate (r+1.4%) Female, 55, SPIA

13 Who chooses PW at normal retirement age? Workers with small accumulations. Compulsion: if original pension < 100% MPG Moral hazard due to MPG: if original annuity > MPG but close, PW maximizes lifetime income (front-loaded payouts > MPG) and also gives bequests to heirs. But payout can’t fall below MPG, so PW dominates annuity. Workers with large accumulation can lose from PW because MPG floor is far below annuity they could afford. Therefore we predict that MPG insurance encourages PW for small accumulations; PW will be clustered near MPG, while most annuities will be much > MPG Evidence: Among normal retirees, av. PW payout near MPG since 1983, while av. annuity payout has been double. Most (79% of) PW pensioners are now at MPG floor; while most (75%) of annuities far > MPG or aren’t eligible for MPG for other reasons.

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16 2) Early vs. normal retirement: Regulations facilitate early retirement Early retirement from system permitted if pension =50% own wage and 110% MPG Months without wages averaged in as 0 Employers and workers can put extra money into retirement accounts to qualify Recognition bonds tradeable, can be sold to insurance companies as part of premium Additional funds given to affiliates who retired in first ten years of system Early retirees can stop contributing and start withdrawing, but can continue working ER regulations a response to unemployment?

17 Role of insurance companies in ER: marketing and regulatory advantages Insurance companies market ER (& annuities)-- tell workers of eligibility, advantages, paperwork Regulatory advantages for insurance companies: –Fees must be implicit (spread—asset-based) while AFP fees must be explicit—do workers avoid explicit fees? –AFP’s afraid to charge high explicit fees for payouts— political backlash—prefer to keep workers contributing; administrative costs of PW –Insurance companies can pay commissions to independent brokers while AFP’s can’t –Insurance companies can make loans to help workers meet early retirement criteria

18 Predictions We would expect workers will “retire early” as soon as eligible--fewer constraints Workers with large accumulations more likely to retire early: –Easier to meet conditions (110% MPG not binding) –Insurance companies and brokers market to them (asset-based fees) –If smaller accumulation want full MPG at normal age Early retirees are more likely to annuitize –Larger accumulations –MPG protection is smaller –Sold by insurance companies and brokers Strong growth of insurance industry likely

19 Evidence Most (60% of) all retirees are early retirees Most (85% of) early retirees annuitize Average size pension is much larger for early retirees Annuity industry has grown from nothing to premiums=$1billion, reserves>$10 billion, mostly from early retirees. Annuity business far > than life business (unusual).

20 Evidence that pensioners use private information about mortality Some pensioners with large accumulations take PW. Do they have shorter expected mortality? We don’t have data on mortality of PW, but we have for annuitants. –A/E deaths much lower in first few years of exposure –A/E much greater for those taking annuities with guaranteed payment periods rather than simple annuities, especially in first few years of exposure So some private information seems to exist, especially about short run mortality, and it influences behavior.

21 Fiscal implications of MPG: contingent liability greater when MPG is wage-indexed (rises) PW is chosen (bequest leakage) Mortality and interest rates are overestimated Early retirement--means that workers don’t accumulate as much as they would by NR Accumulations are small—but PW with large accumulations also subsidized eventually Since account is used up first, govt payments begin when cohort reaches age This is about to happen. So current cash flow greatly underestimates full liability.

22 Lessons for other countries: 1) encouraging story Guarantees and details of regulations become incentives and constraints that shape behavior. Can’t predict behavior without knowing policies. Pensioners and providers respond in predictable ways; if policies change behavior will change In Chile these policies prohibit most lump sum distributions, require price indexed and joint pensions, limit early retirement Constrained choice between annuities and PW has led 2/3 of pensioners to get life-long income insurance through annuitization Insurance companies have supplied annuities and induced demand for them, especially among ER.

23 2) Caveats In Chile incentives for annuitization include aggressive marketing by insurance companies offering ER & regulations giving them competitive edge (demand might be much smaller otherwise); Many workers will choose early retirement if allowed, so conditions must be chosen carefully; Great uncertainty re mortality and interest rates- problem for insurance companies under annuitization, government & pensioners under PW MPG discourages annuitization for small accounts. Payout conditions must be coordinated with safety net provisions, to avoid moral hazard and unexpected public liabilities