Annuities and Aggregate Mortality Risk Martin Weale National Institute of Economic and Social Research 11 th December 2015

The Annuity Puzzle Cannon and Tonks point to the puzzle that conventional, (but rather less index-linked) annuities offer good value for money, but that people do not want to buy them. Annuity sales by volume are now running at about 20% of the level before near-compulsory annuitisation ended. A number of reasons for a reluctance to buy

Explanations of the Puzzle People want to leave bequests- but they can decide what to leave and annuitise the rest. They may want to front-load their income, expecting capacity to enjoy spending to decline with age. They fail to understand how long they may live and the risks associated with longevity. They may see underlying annuity rates as poor despite the suggestion that annuities are good value for money. They may regard annuities as offering over-insurance. Note that indexed annuities imply greater mortality risk than conventional annuities.

Falling Mortality Rates

Outline 1.Examine the case for annuitisation 2.Assess the benefits of annuitisation and the yields needed to justify not annuitizing. 3.Consider annuities with uncertain mortality rates. 4.Explore the payment profiles of optimal responses to aggregate mortality risk. 5.Consider market means of offloading mortality risk.

Consumption with and without Annuitisation

Consumption Profiles No annuity R=0

Annuities and Survival Rates

Consumption with Uncertainty

A Model of Mortality Risk

Survival Probabilities and Life Expectancy (Person aged 65 in 2012)

Annuity Payments with Moderate and High Risk Aversion 

The Value of Protection from Aggregate Mortality Risk Compare with the cost of an annuity which delivers the same life-time expected utility based on expected mortality rates, but with no uncertainty. The difference represents the value put on aggregate mortality insurance. If  =2, the value of insurance is 75p per £100 of annuitized capital. If  =20, the value of insurance is £5.75 per £100 of annuitized capital. On the same basis someone would pay £100-£100/161=£38 per £100 of wealth to be protected from individual mortality risk

Market Comparisons Buy-outs and Buy-ins A buy-out involves paying a third party, usually an insurance company to take over the liabilities of a pension scheme. A buy-in involves paying for protection against particular risks. Buy-ins are priced relative to the cost of meeting liabilities in the gilts market. A small premium relative to gilts suggests that little charge is made for carrying mortality risk. This may, however, reflect the fact that the equity premium is unusually high at the moment.

Conclusions A relatively small excess return can compensate for lack of annuitisation, but investors may not appreciate the risks involved. Indexed annuities have historically been poor value, perhaps because mortality risks are more pronounced than with conventional annuities. In practice, annuitants would probably rather carry aggregate mortality risk for themselves than pay a substantial premium to be protected from it. The market costs of protection from aggregate mortality risk are, however, not clear.