Transcript The New Retirement Challenge

“The Role of Life Annuities in a
Changing Retirement Landscape”
Jeffrey R. Brown
University of Illinois at Urbana-Champaign and NBER
December 13, 2005
Overview
• France and the U.S. are both facing aging societies
– The “old age dependency ratio” in France will increase from 28%
in 2000 to 52% by 2050
– In the U.S., 80 million “baby boomers” are on the verge of
retirement
• Never before in history have so many individuals faced the
challenge of supporting themselves financially for decades
after retirement.
– Increasing life expectancy means that a typical retiree will spend
2+ decades in retirement
– The decline of traditional, defined benefit retirement systems
– Uncertainty about the future of pay-as-you-go benefits
• Financial planning for retirement is made difficult due to
longevity risk, i.e., uncertainty about how long one will live
• Life annuities can help solve this problem by converting
wealth into a steady streams of income that last a lifetime
Retirement Security
• Most public policy, public education, and financial
planning with regard to retirement is focused on the
“accumulation phase”
– How much to save
– Portfolio allocation
– Tax planning
• The “forgotten half” of retirement security is
carefully planning the “payout phase”
–
–
–
–
How fast to consume
Tax planning
Portfolio allocation
How make resources last a lifetime
Longer Lives, Longer Retirements
• People are living longer
– French life expectancy at birth (using period tables)
1900
2000
• MALE
43
75
• FEMALE
47
83
– Source: Berkeley Mortality database
• The result - people are spending more time in
retirement than ever before
– Remaining life expectancy of a 65-year old in France today
• > 17 years for a male
• > 21 years for a female
– Average retiree spends about one-fourth of his or her total life in
retirement
– It is now necessary to financially plan for retirements that could
easily extend up to four decades long!
Insuring “Longevity Risk”
• Financial planning would be easy if we knew with
certainty how long we each would live
– Simply allocate wealth so that it lasts until the day you die
– “Good versus excellent financial planning”
• But length-of-life is highly uncertain
– 65-year-old woman today (in France)
• One in three chance that she will live to age 90
• One in fifty will live to age 100 or beyond
• Uncertainty forces one to trade-off two risks
– If consume too aggressively, you will “run out of money”
before you die
– If consume too frugally, you lower your standard of living
Life Annuities as the Solution
• Life annuities are financial products that
help solve the financial planning problem
• Individual trades a stock of wealth for a flow
of income that lasts as long as individual
lives
• An annuity can provide a higher level of
sustainable income than can be achieved
from a non-annuitized asset
Annuities vs. Life Annuities?
• “Annuity” is a general term used to describe
a concept of payouts over time
– In any standard finance class, an annuity is anything
makes periodic payments for a fixed amount of time
– Not necessarily any insurance aspect
• Many of the products in the U.S. that are
called “annuities” are really just wealth
accumulation devices
– Deferred annuities and variable annuities
– No requirement that assets be converted to life annuity
• This talk is about Iife-contingent annuities
that pay out as long as one lives
A Brief History of Annuities
• Can trace to Roman times
– Roman citizens could make one-time payment, in
exchange for “annual stipends,” or Annua, for life
– In AD 200, Roman jurist Ulpianus compiled first life table:
Life expectancy of a male at age 65 was 5.3 years
• Role of France
– Holland sold annuities as early as 1554 to finance a war
with France
– Annuity pools, known as tontines, operated in France
during 1600s. Operated like a “life lottery”
– In 1700’s Britain issued life annuities in lieu of government
bonds to finance war with France
Economic Theory of Life Annuities
• Yaari (1965): under certain conditions, individuals
should convert 100% of their wealth to annuities
–
–
–
–
–
–
No bequest motives
Actuarially fair annuities
Von Neumann-Morgenstern expected utility
Exponential discounting
Utility of consumption is additively separable over time
No uncertainty other than date of death
• In Davidoff, Brown and Diamond (2005), we show
that, with complete markets, sufficient conditions
for optimality of full annuitization are:
– No bequest motives
– Annuity return to survivors > conventional asset return
What Does This Mean?
• If …
– Consumers do not value leaving a bequest
– The “mortality premium” offered by a life annuity
is enough to offset the “loads” (so that net return
to annuity is higher than return to non-annuity)
– Every (desired) asset is available in both
annuitized and non-annuitized forms
• Then …
– Consumers should annuitize all of their wealth
Intuition
• Annuitized asset return > conventional
asset return to survivors

1  r
1    
 1  r 
1  q 
=load factor, q=mortality rate
• If place no value on money when dead,
then annuity return strictly dominates
• Arbitrage-like gain: if own any bonds,
you can increase utility by selling $1 of
bonds and buying $1 of annuity
Income from Alternative Strategies
9000
8000
6000
5000
4000
3000
2000
1000
Age
Self-ann.
Annuity
11
5
11
3
11
1
10
9
10
7
10
5
10
3
10
1
99
97
95
93
91
89
87
85
83
81
79
77
75
73
71
69
67
0
65
Annual Income
7000
Income from Alternative Strategies
9000
8000
6000
5000
4000
3000
2000
1000
Age
Annuity
Self-ann.
5
11
3
11
1
11
9
10
7
10
5
10
3
10
1
10
99
97
95
93
91
89
87
85
83
81
79
77
75
73
71
69
67
0
65
Annual Income
7000
Income from Alternative Strategies
9000
8000
6000
5000
4000
3000
2000
1000
Age
Annuity
Self-ann.
Amortize to 100
5
11
3
11
1
11
9
10
7
10
5
10
3
10
1
10
99
97
95
93
91
89
87
85
83
81
79
77
75
73
71
69
67
0
65
Annual Income
7000
Income from Alternative Strategies
9000
8000
6000
5000
4000
3000
2000
1000
Age
Annuity
1/LE
Self-ann.
Amortize to 100
5
11
3
11
1
11
9
10
7
10
5
10
3
10
1
10
99
97
95
93
91
89
87
85
83
81
79
77
75
73
71
69
67
0
65
Annual Income
7000
How Does Insurer Make Money?
• While there is tremendous uncertainty
to the individual, aggregate mortality
rates are far less uncertain
• Companies can engage in risk-pooling
and spreading, just like in any other
insurance market
• The key is to pool together large
numbers of individuals with
uncorrelated mortality
Example of What Not to Do
• 1965
• Arles, France
• 47-year old Andre-Francois
Raffray agreed to pay 2,500 francs
per month
• to Jeanne Calment, age 90, until
she died
• In exchange, he would receive her
apartment upon her death
What Happened Next?
• Christmas, 1995  30
years later
• Mr. Raffray dies at age 77
• “On the same day,
Jeanne Calment, now
listed in the Guinness
Book of Records as the
world’s oldest woman,
(age 120) dined on foie
gras, duck thighs, cheese
and chocolate cake”
What Happened Next?
• Christmas, 1995  30
years later
• Mr. Raffray dies at age 77
• “On the same day,
Jeanne Calment, now
listed in the Guinness
Book of Records as the
world’s oldest woman,
(age 120) dined on foie
gras, duck thighs, cheese
and chocolate cake”
It Gets Worse …
• Although Mr. Raffray had already paid
her more than twice the market value
of her apartment …
• Mr. Raffray’s widow (and children and
grandchildren) were required to keep
paying her!
• Ms. Calment’s response?
“In life, one
sometimes
makes bad deals”
Jeanne Calment
What if Markets are not “Complete”?
• Most annuity markets are not complete,
because few companies offer:
– Inflation-indexed life annuities
– Equity-linked life annuities
– Life annuities with payouts contingent on other
outcomes, such as health
• Thus, full annuitization may not be optimal
– If there is a severe mismatch between the
desired consumption path and the annuity
income stream, full annuitization sub-optimal.
– Example: some forms of expenditure shocks
(i.e., medical shocks early in life)
• Key issue – relative liquidity and ability to
match desired consumption path
Simulation Results
• Even when we severely constrain the
choice of available annuities
• And when we model consumer
preferences that create a severe mismatch between the desired
consumption path, and the available
annuity stream
– Use “internal habit” model
• Optimal fractions of annuitized wealth
are quite high – on order of 2/3
The Annuity Trade-Off
• “There is no free lunch”
• Annuities pay a higher return when alive in
exchange for giving up right to wealth upon death
– The resources of those who die young help pay for those
who live a long time
• Advantages of annuities to individuals
– Higher return while living
– Guaranteed income as long as you live
• Disadvantages of annuities
– Cannot bequeath the money (no inheritances)
– If annuity markets are poorly developed, and thus there
are concerns about:
• Pricing
• Liquidity
What Does This Mean in Practice?
• Consumers ought to be annuitizing a large fraction
of their wealth
• Consumer welfare would increase if more asset
types were offered in an annuitized form
– Not just fixed nominal payments
– Inflation indexed annuities
– Life annuity payouts linked to other investment classes
• Stocks, bonds, real estate
• Imagine every asset offered in an annuitized form
• If individuals fail to adequately annuitize on their
own, it may justify government intervention
– Social Security
– Role of annuities in private plans
What is the Reality?
• In most countries, only substantial
source of life annuitization comes from
two sources
– Public pension / Social Security system
– Employer provided defined benefit
pensions
• Individual market for life annuities in
the most countries is quite small
– In U.S., less than $10 billion per year in
new sales of immediate life annuities
The Annuity Puzzle
• Economic theory says annuities are quite
valuable and that retirees ought to hold
most of their portfolio in this form
• Empirical evidence is that most individuals
do not voluntarily annuitize their resources
• Why?
Resolving the Puzzle
• There are lots of possible ways to reduce
annuity demand a standard model
– Bequests
• Little evidence to support this
– High prices (adverse selection or admin costs)
• In U.S., accounts for 10% “load”
– Families as substitutes
– High discount rates
– Uninsured medical expenditure shocks
• Depends on the timing
– Option value of waiting
Resolving the Puzzle
• These “rational” explanations have not
been able to fully explain the observed lack
of annuitization
• Suggests that there are strong “behavioral”
or psychological reasons
– Not wanting to give up control
– “Annuities are a gamble”
– “Ex ante regret”
The Future of Annuitization: U.S.
Four major trends
1. “Baby boomers” about to retire
2. Decline in defined benefit plans
3. Rise of 401(k) plans
4. Uncertainty over U.S. Social Security
system
U.S. Population Pyramid 2000
U.S. Population Pyramid 2050
France Population Pyramid 2000
France Population Pyramid 2050
Defined Benefit Pensions In Decline
• Fewer retirees participate in traditional, defined benefit
pensions that pay steady income for life
– From 1992 to 2001, the percentage of family heads
covered by DB declined from 59.3 to 38.4 percent
70%
60%
50%
Head of
Household
40%
30%
20%
10%
0%
1992
2001
• Many private DB pensions in US are severely under-funded
• Pension Benefit Guarantee Corporation is in deficit
401(k) Plans on the Rise
• The 401(k) is now the dominant form of private
pension in the U.S.
– Defined contribution pension offered through employer
– Tax deferred retirement savings
• But very few 401(k) plans even offer the option to
annuitize
– Estimated to be only 27% of plans in late 1990s that
offered an annuity
– Consensus seems to be that it has dropped sharply in
the recent years
The U.S. Social Security System
• The U.S. Social Security system pays benefits as an inflationindexed, life annuity
• Today, the U.S. Social Security system replaces 42 percent of
earnings on average
– Long-term financial deficits of the system make it likely that
average replacement rates will need to decline in the future
• Social Security is financed on a pay-as-you-go basis
Recommended by Planners
– Today’s workers pay for today’s retirees
– Ratio of workers to retirees is declining rapidly
– Cash deficits begin in just 12 years
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
77
79
73
75
69
71
65
67
61
63
57
59
53
55
49
51
45
47
41
43
37
39
33
35
29
31
25
27
21
23
17
19
13
15
09
11
05
07
Percent of Payroll
Social Security Finances
Figure 2: Cost and Income Rates Under Current Law
20
18
16
Cash Deficits
14
12
Income rate
Cost rate
10
What Does This Mean?
• Social Security replacement rates will likely decline
to address fiscal sustainability
• When combined with decline in DB plans, there is
clear shift toward increased self-reliance in
retirement planning
• In a fully rational world, this should substantially
increase the demand for life annuities
– Saving more is not enough
– Must find a way to make the savings last
A Big Unknown in U.S.
• Social Security personal retirement accounts
– President Bush has called for individuals to be able to
redirect up to 4 percent of earnings into PRAs
– Individuals would be required to annuitize enough to keep
out of poverty
– Joint and survivor annuities as the default option for
married couples
• Would the annuities be provided by government or
private sector?
– Inflation protection
– Role of regulation (state vs. federal)
Future of the Market
• Demand side
– Should see increased demand as traditional sources of
lifelong income decline
– But life annuities are poorly understood
• Consumers
• Financial planners
• Supply side
– Only now seeing much innovation
• Inflation indexed products
• Equity linked products
– Limitations
• Lack of inflation linked corporate bonds
• Regulatory restrictions
Other Public Policy Considerations
• Compulsory life annuitization has
distributional consequences
– Life annuities are designed to transfer wealth
from short-lived to long-lived individuals
– Income and life expectancy positively correlated
• Extent of annuitization may have affect
other government expenditures
– Sufficient annuitization can help prevent
reliance on means-tested programs
• Best policy may be to have annuities be the
default option from public and private plans
– preserve the option for those that want it
Concluding Thoughts
• Annuities are valuable component of any
retirement portfolio
• Policy makers should be looking for ways to
encourage, or at least not discourage, annuitization
– Annuities as the “default” payout option
– Regulations that allow more “complete” markets
• Product innovation
• Regulatory innovation
• Companies should figure out how to market
– Getting incentives right for brokers and agents
– Properly distinguish from the bad reputation of
accumulation products
– Labels: “Personal pension” or “Personal Social Security
plan” rather than “annuity”?