«Abstract: The UK requires individuals with individual accounts to annuitize before the age of 75. Using a time series of annuity prices and ...»
Sandeep Kapur and J. Michael Orszag, "A Portfolio Approach to Investment and Annuitization During Retirement," May 1999 (http://www.econ.bbk.ac.uk/pensions) anticipated some years earlier. Ex post, companies may therefore experience significant losses on annuities even though, ex ante, they were expecting profits.17 Indeed, the combination of low mortality and low interest rates has meant that UK life offices may lose £10 billion or more on guarantees on retirement annuity contracts and several life offices will have to (or have had to) put themselves up for sale as a result of the strain on their free assets. A rough analogy is with disability insurance in the US and the UK; insurers in the US failed to predict morbidity trends accurately and as a result lost money. Our results are quite sensitive to mortality assumptions. Money’s worth values on a fully risk-adjusted basis are therefore higher than our risk-neutral calculations would suggest.
These findings are discussed in more detail throughout the rest of the paper, which has the following structure. In the next section, we provide an overview of the UK pension annuities market and its evolution over time.
Section 3 reviews the Mitchell, Poterba, Warshawsky and Brown (1999) framework which we use for our calculations. Section 4 describes our data and presents our results. A final section concludes.
II. The Market for Pension Annuities in the UK
The market for annuities in the UK is segmented into pension annuities and voluntary (or immediate) annuities. Pension annuities are divided into open market options (OMOs) and compulsory purchase annuities (CPAs).
Compulsory purchase annuities are typically purchased by members of occupational defined contribution schemes,19 whereas open market options There are important incentive problems here in choice of mortality assumptions as ex ante insurers may also use over-optimistic mortality assumptions in order to boost apparent return to capital.
Martin Werth, "Capital Requirement for Protection Products," Munich Re, July 1999.
Some complications arise with non-tax advantaged (‘non-exempt’) top-up schemes for employers earnings over the earnings limit. For such schemes, employers may purchase a “Hancock Annuity” when the employee retires and the capital cost can be deducted by employers. Unlike other annuities in typically are annuities purchased by those in personal pension schemes or Sec. 226 Retirement Annuities for the self-employed. Voluntary annuities (which, as noted above, can be purchased with the lump-sum distribution from a personal pension, or from additional voluntary savings that are not tax-advantaged) are a much smaller market and consist of both temporary annuities and life annuities.
The Association of British Insurers collects data on aggregate annuity volumes. Fig. (1) reports gross annuity payments to immediate (voluntary) annuitants, sponsored (or group) pensioners and individual pensioners.
Sponsored pensioners typically are from occupational schemes and hence payments on such annuities represent the bulk of annuities payouts. Fig. (2) shows new annuity business written by insurance companies. As pension plans have matured and the population has aged, the volume of annuity business has risen.
In 1997, new pension annuities single premia were £4.3 bn whereas the life assurance sector as a whole had over £37 bn in UK new single premia and £4.2 bn in regular premia. To assess the relative size of the annuities market which is dominated by single premia, it is necessary to aggregate single and regular premia business; the typical procedure is to work with annual premia equivalents (APE) which are regular premia plus single premia. Using this APE measure, pension annuities were about 5 percent of new business in 1997. On the other hand, pension business is over 60 percent of total new life assurance business in the U.K. and as a result pension annuity business is expected to grow substantially in the future.
the UK, the Hancock can be commuted and may even be a lump sum (Alec Ure, Taxation of Pension Benefits, Tolley, 1998, pp. 201-202).
Figures 1 and 2 exclude income drawdown, which was introduced in the Finance Act of 1995 because of low annuity yields. As noted above, income drawdown is possible upon retirement and up until age 75, at which time the remaining balance must be annuitized. Income drawdown plans involve taking between 35 percent and 100 person of income, based on a standard annuity, and investing it during a deferral period before annuitization. Before the introduction of income drawdown, individuals had to annuitize in order to draw their pension. In 1997, there were roughly £1.5 bn in volume of income drawdown policies issued.
The annuities market is somewhat concentrated. While there are no publicly available quantity data by company in the UK, we were able to piece together market share data using the regulatory returns of the insurance companies. In 1997, the top 4 annuity companies had 63 percent of the market (for non-linked non-profit single premia annuities). By comparison in 1997, the market concentration of the top 4 insurance companies in terms of new premia for pension business was 34 percent and for overall life insurance business was 20 percent. Similarly, in the United States, the top 4 depository institutions held 13 percent of the market in 1992, the top 4 securities and commodities broker-dealers held 27 percent of the market, and the top 4 insurance carriers held 16 percent of the market.20 In addition, the Herfindahl index for the UK annuities market in 1997 was 1185, slightly above the 1000 threshold viewed as critical by the Antitrust Division of the U.S. Justice Department.21 On the other hand, permanent health or income replacement insurance on disability in the UK is about as concentrated as the annuities market.
Furthermore, data from the U.S. Bureau of the Census show four-firm concentration ratios in the early 1980s in the same range, or higher, for many industries (e.g., 64 percent for primary aluminium, 66 percent for ties and
U.S. Bureau of the Census, 1992 Economic Census, Table 6, "Concentration by Largest Firms:
1992," available at http://www.census.gov.
W. Kip Viscusi, John M. Vernon, and Joseph E. Harrington, Economics of Regulation and Antitrust (D.C. Heath and Company: Lexington, 1992), page 153.
inner tubes, 85 percent for flat glass, and 86 percent for cereal breakfast foods).22 Finally, more recent U.S. manufacturing data, from 1992, show Herfindahl indexes ranging from well under 100 to as high as 2999, with many industries registering over 1000.23 Concentration in the annuities market has remained roughly constant over time. The top 4 annuity writers in 1985 held 59 percent of total business, somewhat lower than the 1997 level of 63 percent, but the Herfindahl index (a broader measure of concentration) was somewhat higher in 1985, at 1273.
Despite the roughly steady level of concentration, there has been some movement in and out of the top spots. For example, Eagle Star was number 2 in 1985, number 15 in 1993 and, by 1997, had fallen to number 24 in terms of volume. The top volume writer in 1997 (Prudential, with over 20 percent of the market) rose to that position only after 1992/93.
Another way of assessing competitiveness in the market is to look at the number of providers and the spread of rates. For a male 65 compulsory purchase annuity, we find that the ratio of the number 5 rate to the top rate is close to 95 percent and that until recently there have been about 30 companies in the market. Fig. 3 shows the evolution over time of this ratio and Fig. 4 shows the same data plotted with interest rates. The price dispersion across the top providers is relatively limited -- well under 5 percent on average, which is within the range of price dispersion for example across gasoline stations in the same town or neighborhood.24 The lack of price dispersion could indicate either a competitive market in which individuals shop across providers, or a collusive market in which providers collectively maintain monopoly-type prices. The low pure cost loadings on annuities is at least U.S. Bureau of the Census, 1982 Census of Manufactures, "Concentration Ratios in Manufacturing" (Washington, DC, 1986). It should be noted that these data apply to a finer level of industry definition (four digit SIC code level) than the annuities market.
U.S. Bureau of the Census, "Concentration Ratios in Manufacturing," 1992 Census of Manufactures Report MC92-S-2, available at http://www.census.gov.
J. Daniel Khazzoom, "Making Pay-at-the-Pump Public and Industry-Friendly," unpublished draft, Resources for the Future, October 1998.
suggestive that the lack of price dispersion in the annuities market is of the former rather than latter type.25
Note: The quotes are based on a premium of £10,000 and exclude specialist annuities. On July 9, 1999, the ratio was just over 96 percent.
Analysis of collusion over pricing in the insurance industry is problematic because of the important role played by actuaries in pricing. The other issue here is that companies have an incentive to use forecasts with smaller mortality improvements as, in the short run, it improves apparent returns to capital and profitability.
Fig. 4. Male 65 compulsory purchase yields relative to interest rates
An interesting feature of the market is that, even though the top rates track interest rates closely, the time between rate changes for annuity providers can be surprisingly long. The average time between rate changes for one annuity provider in our sample was 28 ½ months. The average time between rate changes across all providers is closer to 2 months, with more rate changes in periods of interest rate volatility. We believe most of this "delay effect" has to do with settlement periods in setting up annuity contracts in the UK and the associated transactions costs of changing rates unless there are large movements in interest rates. Even so, some providers with large market shares do not adjust their rates frequently despite movements in interest rates, suggesting at least some element of mispricing and market imperfection. In other words, the relatively high concentration may manifest itself in the responsiveness of prices to market fundamentals more than in mean prices across different interest rate environments.
Source: Authors’ analysis, Investment Intelligence annuity data.
Some other features of the annuities market are relevant:
• First, most annuity business is either transacted in-house or through independent financial advisers. Commissions to independent advisers run at about 1 percent, which is well below those payable on other lines of business. For example, income drawdown policies of £100,000 attract roughly 3 percent in commission. Independent brokers such as Annuity Direct and Annuity Solutions can help independent advisers and consumers find the best annuity quotes. Occupational defined contribution schemes may in some cases offer in-house annuities at attractive rates but generally they will enter into a group purchase arrangement or get quotes on rates for members.
• Second, there is a natural correlation between past volumes of pension business and annuity business because of individuals who do not exercise their open market options. Prudential sells annuities through a separate business unit and hence files separate regulatory returns. Using these regulatory returns, we note that in 1997, they underwrote 36,360 annuities to internal annuitants and 4,992 to external annuitants.26 If the largest company mirrors the industry, only about 12 percent of annuitants exercise their open market option to get the best rate on the market. But
those who do exercise open market options tend to have larger accounts:
External business represents about 41 percent of the volume reported on the 1997 Prudential regulatory returns, so that the internal business necessarily involves smaller account balances. Indeed, in 1997 the average internal account balance was just over £14,000 which is smaller than Prudential Annuities minimum premium of £20,000 for external business.
Furthermore, Axa Sun Life currently has a minimum premium of £50,000 for external business. Given such restrictions -- as well as the fact that consumers with small balances are likely to have lower income and education levels -- it is perhaps not surprising that, at least according to anecdotal evidence, most people with small balances in their pension accounts at retirement do not go to an independent adviser to get alternative independent quotes.
• Third, regulatory returns for the top companies indicate that most of the business volume is in level annuities. Some companies do not split individual and group business on their regulatory filings so that some of these differences could encapsulate group arrangements. However, some of the companies do separate individuals and groups (e.g., Standard Life and Norwich). It has been estimated by Annuity Bureau that about 80 These calculations use Column 1 of Form 47 of the Prudential Annuities DTI returns. In 1996, these numbers were 31,814 (internal) and 4,917 (external).
percent of open market business is ordinary level annuities without escalation.
• Fourth, many companies write index-linked annuities, and the average size is much larger on those annuities. For example, the 1997 Prudential Annuity returns indicate that the average external premium on an indexlinked annuity was over £151,000 whereas the average on an unlinked was just £66,524. The second largest writer of annuity business in 1997 was Standard Life and for individual index-linked annuities the average size was £47,461 whereas for nonlinked annuities it was £17,656. Norwich Union, with the third largest volume, also exhibited similar patterns, with the average size of an index annuity of £49,720 and the average size of a level annuity of £29,898. At Equitable Life, the fourth largest provider of annuities in 1997, the average size of an index-linked annuities was also close to 50 percent higher than a non-linked annuity. Index-linked annuities, however, represent a small percentage of policies. For Norwich Union, index-linked annuities represented about 1.7 percent of policies.