«Abstract: The UK requires individuals with individual accounts to annuitize before the age of 75. Using a time series of annuity prices and ...»
The Value for Money of Annuities in the UK:
Theory, Experience and Policy
Mamta Murthi1, J. Michael Orszag2 and Peter R. Orszag3
Abstract: The UK requires individuals with individual
accounts to annuitize before the age of 75. Using a time series of
annuity prices and quantities, we apply the methodology of
Mitchell, Poterba, Warshawsky and Brown (1999) to examine
the value of UK market annuity rates relative to theoretical
values. We find that the pure administrative cost loadings on UK annuities are relatively low. Adverse selection costs account for the majority -- perhaps one-half to two-thirds -- of the total annuity costs for the typical individual. While results depend significantly on mortality assumptions, the total financial losses for the typical worker from charges or market imperfections in the annuities market are much lower than the costs for the accumulation stage in the UK found by Murthi, Orszag, and Orszag (1999).
I. Introduction Annuitization is often perceived to be among the more difficult areas of social security privatization and reform. For example, an issue brief in The authors thank (without implicating) numerous reviewers and those who have provided us with information and comments through discussions. We thank Amy Finkelstein for extensive discussions.
We are also especially grateful for the existence of comprehensive data meticulously collected over an extended period of time by Investment Intelligence (a division of the Research Department), and especially Thesys Ltd. We are also particularly grateful to Yvonne Murray of Thesys.
Clare Hall, Cambridge CB2 1ST, UK. Email: email@example.com Department of Economics, Birkbeck College, London W1P 2LL. Email: firstname.lastname@example.org
Sebago Associates, 951 Old County Rd., Suite 194, Belmont, California 94002. Email:
email@example.com Averting the Old Age Crisis4 identified the core problems of adverse selection, mortality risk, and high commissions/misselling associated with private annuities markets. In addition to these core problems, other potential concerns include the yields on private annuities and the competitiveness of the private annuities market. Low annuity payouts also tend to attract political attention, especially since the relatively poor rely on annuities as a way of insuring against outliving their accumulated savings. Not surprisingly, therefore, the degree to which annuitization and the annuity market is regulated is an extremely contentious public policy issue.
The UK has a long experience with mandatory annuitization of pension funds, dating back to the Finance Act of 1921.5 The Finance Act of 1956 introduced the current requirement of annuitization before age 75, which it applied to individual pension accounts for the self-employed (the annuities were known as Sec. 226 Retirement Annuities). In 1988, when a broader form of individual accounts known as personal pensions were introduced, the
system became somewhat more complicated:
• The portion of an individual account funded by tax rebates must be fully annuitized, and the annuity must be purchased at some point between age 60 and age 75. The annuity payments must be the same for men and women: providers cannot provide lower annual payments to women to reflect their longer life expectancies. 6
• The portion of an individual account funded by additional contributions does not have to be entirely annuitized. In particular, up to 25 percent of the accumulated balance from this component of the individual account can be withdrawn tax-free in a lump sum. If the account holder retires Averting the Old Age Crisis, Oxford, 1994, pp. 329-331.
For an overview of mandatory annuitization in the UK, see Oonagh McDonald, "Income in Retirement: Are Annuities the Answer?", Association of Unit Trusts and Investment Funds, 1999.
These ‘protected rights’ annuities must now also be index-linked up to a maximum of 5% and be underwritten on a joint life basis, even if the individual is not married.
before the age of 75,7 the rest of the account can be distributed in one of three ways: (1) an annuity purchased from a life insurance company, (2) an annuity purchased from a life insurance company providing the individual account8 or (3) an income drawdown facility, under which the retiree withdraws specific amounts of money while most of the balance continues to earn market returns. At 75, regardless of which option is initially chosen, the balance of the account must be converted into an annuity.9
• All pension annuity income is taxed as ordinary income. The tax-free lump sum may be used to purchase an immediate (or ‘purchased life’ or ‘voluntary’) annuity, under which annuity payments are split up into returns on capital and income for taxation purposes. Since capital is taxed at lower rates, particularly for those on lower income, voluntary annuities have particular tax advantages. 10 Workers do not have to begin receiving the two components of the individual account -- the part funded by tax rebates, and the other part funded by additional contributions -- at the same time. If workers die before annuitizing their account, the balance of the account enters their estate. The other important point to note is that individuals are not required to annuitize their account with the financial provider from the accumulation stage: under the Individuals designate a retirement age, normally required to be between 50 and 75, for their voluntary retirement accounts.
In practice in the UK, the vast majority of personal pensions are underwritten through life insurance companies or vehicles.
There are a wide variety of annuity types, including level annuities, which pay the same amount in pounds for the term of the annuity; unit-linked annuities, which pay an amount linked to stock prices for the term of the annuity; index-linked annuities, which pay an amount linked to the retail price index for the term of the annuity; and with-profits annuities, which pay an amount linked to the profits of the provider. Other choices include whether the annuity is single life or joint; minimum guarantee or not;
and the frequency of payment (monthly, quarterly, annual, etc.). The annuities market thus presents a wide variety -- perhaps a bewildering variety -- of choices for retirees.
One anomaly is that impaired life annuities involve less proportional tax relief because capital amounts are the same as ordinary voluntary annuities but income is greater.
so-called open-market option, individuals are allowed to annuitize their account with any life insurance company. In summary, although the system is now more complicated, it still involves (in most cases) a requirement to annuitize before age 75.
The UK’s long experience with compulsory annuitization, along with the existence of inflation-indexed annuities that are less common or nonexistent in many other countries, provides a unique setting to investigate the operations of private annuities markets and policy lessons. Finkelstein and Poterba (1999)11 have used UK data to measure adverse selection by comparing rates on voluntary and compulsory pension annuities, and are currently extending their work using more extensive data. Their results may prove important in assessing the degree to which differentials in annuity rates from theoretical annuity yields are due to adverse selection.
The overall cost loading on an annuity for the typical individual comprises two components: an adverse selection cost and an administrative cost. Adverse selection arises in the annuities market because people with longer-than-average life expectancies are more likely to purchase annuities, and more likely to purchase larger annuities, than people with shorter-than-average life expectancies. (Given the mandatory annuitization rules in the UK, the adverse selection effects occur both because of the timing of annuitization, and because of adverse selection in who holds individual accounts during the accumulation phase.) The insurance companies that sell annuity policies consequently price them based on the longer life expectancies of the annuitants. A typical person with average life expectancy must therefore pay a higher price for an annuity than would be justified based on average life expectancy. It should be noted that the annuity "cost" is a financial loss only relative to the actuarially fair annuity for that typical
Amy Finkelstein and James Poterba, "Selection Effects in the Market for Individual Annuities:
Evidence from the United Kingdom, " 1999.
individual; it does not necessarily suggest that the annuitant suffers a utility loss, nor does it necessarily provide a metric of the social welfare losses from annuitization. The second component of annuity costs consists of the administrative costs the annuity provider bears; such costs cover expenses such as marketing, commissions to agents, investment costs, overhead, and profits.
Our focus here is on pension annuities in 1999, including comparisons with earlier years. Using the money’s worth ratio (MWR) methodology of Mitchell, Poterba, Warshawsky and Brown (1999)12 -- we reach several
• First, the overall annuity cost loading is roughly 10 percent of the account value for the typical individual. That is, for a typical individual, we find that the annuity payments are about 10 percent below what would be implied by anticipated population mortality and the current yield structure on riskless government bonds. We also find this figure has not changed much over time.
• Second, half to two-thirds of the overall cost loading is due to adverse selection costs. The pure administrative cost loading on annuities is thus no more than 5 percent. Poterba and Warshawsky (1999) reach similar conclusions for the annuities market in the United States: they find that the majority of annuity costs is accounted for by adverse selection rather than traditional cost loadings.13
• Third, even with the adverse selection costs, the overall costs of the annuitization stage in the UK are small relative to the accumulation phase.
Mitchell, Olivia S., James M. Poterba, Mark Warshawsky, and Jeffrey R. Brown, 1999, "New evidence on the money’s worth of individual annuities," American Economic Review (forthcoming).
James Poterba and Mark Warshawsky, "The Costs of Annuitizing Retirement Payments from Individual Accounts," NBER Working Paper 6918, January 1999.
In Murthi, Orszag and Orszag (1999),14 we decomposed charges over the lifetime of an individual in a personal pension in the UK and found that over 40 percent of an individual account's value is dissipated through fees and charges. The contribution of annuities costs to the overall costs to an individual in the UK, however, was relatively very small. In our earlier work, we concluded that the cost of annuitization for the typical individual was 10 percent of the accumulated balance upon retirement -which is consistent with our conclusion in this paper. Costs during the accumulation phase, however, amounted to 36 percent of the accumulated balance. (Taking account of interaction effects, the combined accumulation-annuitization costs amounted to 43 percent.) The annuitization phase is thus significantly less costly than the accumulation phase, and would be even less costly if adverse selection effects were reduced.
Empirical magnitudes are often in the eye of the beholder, and we do not intend to evaluate whether 10 percent (or even 5 percent) is "high" or "low". But whatever the resolution of that semantic debate, it is clear that annuitization costs are significantly lower than accumulation costs in the UK.
There are a variety of explanations for this:
• Sales commissions are low relative to other financial products.
• Annuities are commoditised, so it is easy for consumers or advisers to compare rates across products.
• The annuity amounts are relatively large, so customers have an incentive to search extensively.
• The lack of availability of fine-grained mortality data limits the ability of providers to cherry-pick customers.
Mamta Murthi, J. Michael Orszag, and Peter R. Orszag, “The Charge Ratio on Individual Accounts:
Lessons from the U.K. Experience,” Birkbeck College Working Paper 99-2, March 1999 (University of London), available at http://www.econ.bbk.ac.uk/ukcosts
• Economies of scale and other benefits to providers from attracting market share in a growing market reduce prices to consumers.
• For providers, annuities are a useful balance against life insurance liabilities -- so that they are willing to sell them at quite competitive prices.
• Once sold, annuities are relatively easy to administer -- and hence administrative costs are low.
• Pension annuities purchases in the UK are irreversible, so providers do not bear lapse risk.
Our overall results, however, have a number of important caveats.
Among these caveats are:
• First, about 90 percent of individuals purchase level annuities, rather than index-linked or investment-linked annuities.15 As noted by Kapur and Orszag (1999)16, there may be welfare losses associated with such an investment choice.
• Second, our focus is on means, not distributions. And although we find the annuities market to have low costs relative to the accumulation phase for the typical worker, a large fraction of individuals may not be getting good money’s worth on their annuity purchases. The paradox arises because relatively unsophisticated investors with small pension funds often do not exercise their option to buy an annuity from the most competitive provider in the market.
• Third, a further problem relates to mortality assumptions. Mortality experience in the UK has been considerably lower than had been The annuity broker Annuity Bureau reports 83.5% of its customers buy level annuities and only 5.3% opt for any type of escalating annuity (Peter Quinton, "Good News for Innovators", Pensions Management, June 1999, p. 82). The proportion purchasing level annuities for the population will be higher than this because of the composition of the consumer base of the Annuity Bureau.