ANNUITY MARKETS: THE CHALLENGE OF INFLATION Dimitri Vittas Consultant The World Bank

FIXED NOMINAL ANNUITIES 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. 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%. 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. 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. 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.

INFLATION AND THE DECLINE IN REAL VALUES Rate\Years %61%85%94% 5%39%62%77% 3%26%45%59% 1%9%18%26% 0.5%5%9%14%

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

ESCALATIING 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. 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. 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. 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. 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.

FIXED REAL ANNUITIES Fixed real annuities provide protection against longevity, investment and inflation risks. 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. 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. 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. In the absence of inflation-linked securities, annuity providers also charge an inflation risk premium that raises their cost.

SHORTCOMINGS OF FIXED REAL ANNUITIES The main disadvantage of fixed real annuities is their high cost relative to nominal and variable 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. 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. 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.

FIXED REAL ANNUITIES: THE CASE OF CHILE Chile does not authorize the use of fixed nominal annuities. For retirees who annuitize, it mandates the use of either fixed real annuities or variable annuities. Chile does not authorize the use of fixed nominal annuities. For retirees who annuitize, it mandates the use of either fixed real annuities or variable annuities. In 2008, 66% of all primary pensioners had an annuity and 34% used a phased withdrawal. 90% of early retirees opted for a life annuity, but only 36% of old age pensioners. In 2008, 66% of all primary pensioners had an annuity and 34% used a phased withdrawal. 90% of early retirees opted for a life annuity, but only 36% of old age pensioners. There was a slowdown in recent years in the growth of the annuity market because of stricter conditions for early retirement. 20,000 new policies are issued each year, down from close to 30,000 before 2004, for a total premium of 50 million UFs. There was a slowdown in recent years in the growth of the annuity market because of stricter conditions for early retirement. 20,000 new policies are issued each year, down from close to 30,000 before 2004, for a total premium of 50 million UFs. Variable annuities were authorized in 2004, in combination with fixed real annuities, but there has been little activity. Variable annuities were authorized in 2004, in combination with fixed real annuities, but there has been little activity.

FIXED REAL ANNUITIES: THE CASE OF CHILE II In Chile there is ample supply of medium- to long-term inflation instruments, including government, corporate and mortgage bonds. However, inflation bonds with maturities of over 20 years are not widely available. In Chile there is ample supply of medium- to long-term inflation instruments, including government, corporate and mortgage bonds. However, inflation bonds with maturities of over 20 years are not widely available. Thus, annuity providers suffer from a duration mismatch between their assets and liabilities. This is estimated at around 4 years. Thus, annuity providers suffer from a duration mismatch between their assets and liabilities. This is estimated at around 4 years. A new electronic quotation system was introduced in 2004 to improve the marketing of annuities and lower costs. Annuity commissions have fallen to 1.5%. They exceeded 6% in the 1990s. A new electronic quotation system was introduced in 2004 to improve the marketing of annuities and lower costs. Annuity commissions have fallen to 1.5%. They exceeded 6% in the 1990s.

FIXED REAL ANNUITIES: THE CASE OF CHILE III Annuitants appear to be getting a good deal, although declining real interest rates have caused a significant fall in annuity conversion factors. Annuitants appear to be getting a good deal, although declining real interest rates have caused a significant fall in annuity conversion factors. The Money’s Worth Ratio (MWR) for joint life annuities was calculated at 108% in March 2005, using the government bond yield curve. This fell to 89% when the corporate bond yield was used. The Money’s Worth Ratio (MWR) for joint life annuities was calculated at 108% in March 2005, using the government bond yield curve. This fell to 89% when the corporate bond yield was used. The true level of the MWR is probably in between. The corresponding MWRs for the UK were estimated at 88% and 78% respectively. The true level of the MWR is probably in between. The corresponding MWRs for the UK were estimated at 88% and 78% respectively.

REAL YIELDS ON TIPS IN US & CHILE ANNUITY RATES & ACFs IN CHILE

REAL INTERST RATES AND ANNUITY CONVERSION FACTORS Rate\Years %9.6%8.0%7.1% 3%8.2%6.7%5.7% 1.5%7.5%5.8%4.8% 0%6.7%5.0%4.0%

ROLE OF INFLATION BONDS: MOST OTHER COUNTRIES In most other countries, the main provider of inflation bonds is the government. In most other countries, the main provider of inflation bonds is the government. The supply of such bonds has increased in recent years, but even so it would be wholly inadequate if the demand for fixed real annuities were to take off in other countries as it has done in Chile. The supply of such bonds has increased in recent years, but even so it would be wholly inadequate if the demand for fixed real annuities were to take off in other countries as it has done in Chile. Thus, in addition to being expensive, inflation bonds are also in short supply. Thus, in addition to being expensive, inflation bonds are also in short supply. Getting the government to issue more of these bonds would imply heavy reliance on the government for ensuring that the private pension system delivers on its promises. Getting the government to issue more of these bonds would imply heavy reliance on the government for ensuring that the private pension system delivers on its promises.

“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. 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. 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. 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. US inflation averaged more than 3% per year over the past 30 years.

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. 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. 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. 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. Variable annuities require a robust system of regulation and supervision and a high level of transparency and integrity on the part of annuity providers.

TYPES OF VARIABLE ANNUITIES Variable annuities take two main forms: profit participating; and unit-linked. Variable annuities take two main forms: profit participating; and unit-linked. The first type allows for some smoothing of returns. They often take the form of “guarantee and bonus” annuities, combining guaranteed minimum benefits with annual bonuses that target the preservation of the real value of annuity payments. The first type allows for some smoothing of returns. They often take the form of “guarantee and bonus” annuities, combining guaranteed minimum benefits with annual bonuses that target the preservation of the real value of annuity payments. In unit-linked annuities, the investment risk is borne by annuitants. They are often offered with caps and floors on their returns which lower their exposure to the high volatility of equity returns. In unit-linked annuities, the investment risk is borne by annuitants. They are often offered with caps and floors on their returns which lower their exposure to the high volatility of equity returns. Unit-linked annuities are more transparent than profit-participating annuities. Unit-linked annuities are more transparent than profit-participating annuities.

THE REGULATION OF VARIABLE ANNUITIES Variable annuities require a sophisticated system of regulation and supervision. Variable annuities require a sophisticated system of regulation and supervision. Clear rules should be adopted for the initial calculation of annuity payments and their annual adjustment in the light of net investment returns, inflation, longevity experience, and operating costs. Clear rules should be adopted for the initial calculation of annuity payments and their annual adjustment in the light of net investment returns, inflation, longevity experience, and operating costs. The rules should specify the principles that would need to be observed in the creation of sound reserves and the distribution of profits between policyholders (annuitants) and shareholders. The rules should specify the principles that would need to be observed in the creation of sound reserves and the distribution of profits between policyholders (annuitants) and shareholders.

THE MARKETING OF VARIABLE ANNUITIES The marketing of variable annuities would also need to be tightly regulated to prevent mis-selling and other deceptive practices. The marketing of variable annuities would also need to be tightly regulated to prevent mis-selling and other deceptive practices. A central register comparing and publicizing the performance of different providers on a consistent and meaningful basis should be established. A central register comparing and publicizing the performance of different providers on a consistent and meaningful basis should be established. The example of Chile in setting up a centralized electronic quotation system would merit detailed consideration. This lowers search costs, minimizes the influence of brokers, and promotes greater transparency and competition. The example of Chile in setting up a centralized electronic quotation system would merit detailed consideration. This lowers search costs, minimizes the influence of brokers, and promotes greater transparency and competition. The same entity could combine the two tasks of centralizing quotations and comparing performance. The same entity could combine the two tasks of centralizing quotations and comparing performance.

VARIABLE ANNUITIES IN DENMARK AND SWEDEN Variable annuities of the “guarantee and bonus” type are widely used in Denmark and Sweden. Recent years have seen significant growth in unit-linked annuities with some guarantees. Variable annuities of the “guarantee and bonus” type are widely used in Denmark and Sweden. Recent years have seen significant growth in unit-linked annuities with some guarantees. The regulation and supervision of variable annuities appears to be robust in these two countries. It is in principle based on transparency, adequate reserving and strong competition among providers. The regulation and supervision of variable annuities appears to be robust in these two countries. It is in principle based on transparency, adequate reserving and strong competition among providers. A major part of the market is based on collective labor agreements, which favor defined-contribution plans and encourage the use of variable annuities, including both life and term annuities. A major part of the market is based on collective labor agreements, which favor defined-contribution plans and encourage the use of variable annuities, including both life and term annuities. Involvement of two large state entities, ATP in Denmark and PPM in Sweden, is having an impact on the market. Involvement of two large state entities, ATP in Denmark and PPM in Sweden, is having an impact on the market. However, there is no readily accessible compilation of data on the performance of variable annuities. However, there is no readily accessible compilation of data on the performance of variable annuities.

CONCLUDING REMARKS Most annuity products suffer from important shortcomings. Most annuity products suffer from important shortcomings. Some are exposed to investment and inflation risk, others only to inflation risk, others to fixed low returns. Some are exposed to investment and inflation risk, others only to inflation risk, others to fixed low returns. All annuity products suffer from liquidity risk, while fixed products are also exposed to annuitization risk. All annuity products suffer from liquidity risk, while fixed products are also exposed to annuitization risk. The best way to handle all these risks is to promote a combination of payout options. The best way to handle all these risks is to promote a combination of payout options.

COMBINATION OF PAYOUT OPTIONS The combination of payout options should require the use of a minimum level of fixed real annuities. In many countries, this would be provided by the first pillar. In Chile, this is equal to the Minimum Pension Guarantee. The combination of payout options should require the use of a minimum level of fixed real annuities. In many countries, this would be provided by the first pillar. In Chile, this is equal to the Minimum Pension Guarantee. For additional levels of annuitization, retirees should be free to choose between fixed real annuities, escalating, annuities, variable annuities, phased withdrawals and even self-annuitization. For additional levels of annuitization, retirees should be free to choose between fixed real annuities, escalating, annuities, variable annuities, phased withdrawals and even self-annuitization. Lump sums and self-annuitization could play a significant part, provided retirees are also required to purchase deferred annuities that would generate in older age an adequate supplement to the income from the first annuity. Lump sums and self-annuitization could play a significant part, provided retirees are also required to purchase deferred annuities that would generate in older age an adequate supplement to the income from the first annuity. FIXED NOMINAL ANNUITIES SHOULD BE BANNED! FIXED NOMINAL ANNUITIES SHOULD BE BANNED!