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«Abstract: The UK requires individuals with individual accounts to annuitize before the age of 75. Using a time series of annuity prices and ...»

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Table 4 also demonstrates the effect of using higher discount rates on the value for money calculations. As we might expect, using higher discount rates make the value for money appear lower. Using higher discount rates also appears to reduce the dependence of the value for money on gender and age. This effect is greater in the case where the annuitant life tables are used.

This is probably because higher discount rates reduce the effect of differences in the effective duration of payouts.

In Table 5 we compare the value for money for three types of annuities:

level, 3 percent escalating, and indexed (real). We use zero-coupon yields for discounting and consider both population and annuitant life tables. As might be expected, the starting rates for escalating and real annuities are lower than for level annuities. For example, for a 65-year old man, the average (median) open market rate for a 3 percent escalating annuity on April 30, 1999 was £659.5 per year, 22 percent less than the level rate of £851. For real annuities, the average starting rate was £610.7, 28 percent less than the level rate. For women of the same age, the difference from the level rate was somewhat smaller, and for couples somewhat greater. In all cases, the differential tended to fall with age.

Comparing level annuities with escalating annuities, we observe that the value for money is generally higher for the former. The higher value for money becomes more pronounced when population life tables are used as the effective payout period is shorter. For example, for a 65-year old man facing the mortality prospects of the general public, the payout per £’s worth of premium is 88.6 pence for a 3 percent escalating annuity compared to 89.7 pence for a level annuity. Using annuitant mortality tables raises makes the payout 97.1 pence in the £ for an escalating annuity compared to 96.8 pence in the £ for a level one. For a 70-year old man, the money's worth ratios for level and escalating annuities are 0.875 and 0.852 respectively if population mortality tables are used, and 0.955 and 0.947 if annuitant tables are used.

Likewise, indexed annuities offer significantly lower value for money than level annuities. In general, there is a difference in value of around 10 pence in the £ between level and real annuities. Thus, a 65-year old man facing general mortality risks can expect a payout of 80 pence for every £’s worth of premium on buying an indexed annuity, compared to 89.7 pence for a level annuity. If he faces the risks of the average annuitant, he can expect a payout 87.8 for every £ of premium used to purchase an indexed annuity compared to 96.6 pence for every £ in a level annuity. As in the case of escalating annuities, the reduction in value for money compared with level annuities falls with age, but with indexed annuities, the reduction is far more gradual.

The high cost of inflation insurance may help to explain why indexed annuities have proved to be relatively unpopular. It would be hard to ascribe the higher cost to cost of bearing inflation risk as insurers can avoid some if not all of this risk through inflation-indexed bonds. A part of the explanation may lie in selection effects as real annuities are likely to be favoured by those who expect to live long. Similar selection effects may operate in the market for escalating annuities.

In Table 6 we explore the costs associated with policies of different sizes by comparing the value for money of two policies with premiums of £10,000 and £100,000. Annuity rates associated with higher initial premiums are more than proportionately higher. For example, the average rate for a £100,000 policy in April 1999 was £8,726.4 per year compared to £851 from a £10,000 policy. This pattern is repeated at all ages and among women and couples. As richer individuals can be expected to be live longer, we expect the effect of socio-economic background to be reflected in rates, possibly lowering them below the rates for smaller policies. However, it appears that savings in administrative or other costs in the case of large policies more than compensate insurers for the likely longer duration of payment. The better rates associated with larger are reflected in the rise in the value for money with policy size in Table 6.

In Table 7 we examine changes in the value for money during the 1990s. This table is confined to open market options for men aged 65 and 70 as these were the only comparable data we were able to obtain for the period in question.48 Future income streams are discounted using the term structure of yields on UK government bonds prevalent at the time the annuity was written. While past assumptions about interest rates are relatively easy to obtain, the same is not true of past assumptions regarding mortality improvements. For simplicity, we assume mortality improves at the same rate for all cohorts irrespective of year. (Thus, for the general population we assume the mortality improves at the rate embodied in the latest GAD projections, and for annuitants CMIR 17.) However, we assume that mortality starts to decline from a higher level for earlier cohorts. So, for example, we assume that the cohort attaining 65 in 1994 has conditional The data are for level annuities, payable in advance, with a five year guarantee.

probability of dying within a year which is over 7 percent higher than for the cohort attaining 65 in 1998.49 The use of uniform rates of mortality improvement is admittedly an ad hoc assumption, and involves the use of information that was not available at the time. For annuitants, it would probably not correspond with the assumptions being made at the time to price annuities. Indeed, the further back in time we go, the greater is likely to be the overstatement of mortality improvement. Nonetheless, it provides a relatively straightforward way of examining the value for money of annuities in the past.





Table 7 suggests that at least for the past 5 years (1994 onwards), there has been no trend in the value for money for annuities. This holds whether we use population or annuitant life tables. The MWRs for 1990 however appear somewhat higher. Our hunch is that this probably has to do with the use of the mortality improvement factors which were not prevalent at the time rather than a genuine decline in the value for money since the start of decade. It is also consistent with the ex-post losses on annuity contracts which has been a feature of the market.

V. Conclusions

Our results suggest that for the typical individual in the UK, the cost of annuitizing a pension upon retirement is approximately 10 percent of the account balance. Perhaps half to two-thirds of this cost arises from adverse selection; the pure cost loading on annuities is relatively low. Compared to the costs during the accumulation (pre-retirement) phase for the typical individual, annuitization costs are relatively low. Murthi, Orszag, and Orszag (1999) find that accumulation costs total 36 percent of the final account balance for the typical individual; annuitization costs of 10 percent are thus The base rates for 1990 are from English Life Tables 14. For 1994 and 1998, we extrapolate between the base rates in English Life Tables 15 and the GAD projections. For annuitants, we obtain less than one-third the accumulation costs. Furthermore, in a broader sense, the cost of annuities in both the UK and US seem to derive primarily from adverse selection. In a mandatory system of private accounts with complete coverage of the population and mandatory annuitization, adverse selection costs should be substantially reduced -- so that annuitization costs would be relatively small compared to accumulation costs.

We also find that concentration is relatively high in the annuities market, but that price dispersion is relatively low and that profits do not seem excessive (the pure cost loading on annuities is relatively low, at least suggestive of low profit margins).50 Interestingly, providers seem to respond sluggishly to changes in interest rates. This price stickiness seems unusual in a financial market.

Finally, our results focus only on means. They do not fully reflect the range of risk, ages, asset portfolios, and mortality-income variances across the annuitant population. A full analysis of the annuities market should take these factors into account in evaluating the value of annuitization across individuals.

the base rates for 1990 from PML80. For 1994 and 1998, we extrapolate from PML92.

It should be noted, however, that returns to capital may be high even though pure cost loadings are low, since the capital-premium ratio can be quite low.

Bibliography David Coleman and John Salt (1992), “The British Population: Patterns, Trends and Processes”, Oxford University Press.

Amy Finkelstein and James Poterba (1999), “Selection Effects in the Market for Individual Annuities: Evidence from the United Kingdom”, Draft: May 1999.

Friedman, B, and M. Warshawsky (1990), “The Cost of Annuities:

Implications for Savings Behaviour and Bequests”, Quarterly Journal of Economics, 105, 135-54.

Sandeep Kapur and J. Michael Orszag, A Portfolio Approach to Investment and Annuitization During Retirement, Draft: May 1999, available at http://www.econ.bbk.ac.uk/pensions M. Zaki Khorasanee, Annuity Choices for Pensioners. Journal of Actuarial Practice, 1996, 4(2), pp.229-255.

Oonagh McDonald (1999), “Income in Retirement: Are Annuities the Answer?”, Association of Unit Trusts and Investment Funds, 1999.

Michael Marmot, George Davey Smith, Stephen Stansfield, Chandra Patel, Fiona North, J. Head, Ian White, Eric Brunner, and Amanda Feeny, “Health Inequalities among British Civil Servants: The Whitehall II study”, Lancet, June 8, 1991, pages 1387-93.

Moshe Milevsky(1998), “Optimal Asset Allocation Towards the End of the Life Cycle: To Annuitize or Not To Annuitize?”, Journal of Risk and Insurance, 65, 3, 401-426.

Mitchell, O., J. Poterba, M. Warshawsky and J. Brown (1999), “New Evidence on the Money's Worth of Individual Annuities”, American Economic Review, forthcoming.

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.

James Poterba and Mark Warshawsky, “The Costs of Annuitizing Retirement Payments from Individual Accounts”, NBER Working Paper 6918, January 1999.

Alec Ure (1998), “Taxation of Pension Benefits”, Tolley, pages 201-202.

–  –  –

Notes: Each cell indicates the probability of a person in the relevant age group dying before reaching the next age group. Socio-economic classes range from I (uppermost) to V (lowest).

Source: Health Inequalities Decennial Supplement, Office for National Statistics, September 1997.

Table 2: General Population and Annuitant Mortality Projections (x 100) for Individuals Aged 65 in 1998-99

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65 2.1 1.5 1.2 1.0 1.1 70 3.2 2.5 1.9 1.8 1.8 75 4.9 4.0 3.1 3.3 3.0 80 7.8 6.5 5.2 5.7 5.0 85 11.9 10.1 8.5 9.3 8.2 90 17.0 15.1 13.7 14.5 13.1 95 23.5 21.6 21.3 21.2 20.4 100 31.4 29.1 31.6 28.8 30.4 105 45.2 37.4 44.7 36.9 43.2 110 66.7 45.8 59.8 44.4 58.0

Females:

65 1.1 0.9 0.6 0.8 0.4 70 1.7 1.5 1.1 1.3 0.8 75 2.7 2.6 1.9 2.2 1.6 80 4.6 4.3 3.5 3.8 3.2 85 7.8 7.1 6.3 6.2 6.2 90 12.7 11.3 10.9 9.8 11.3 95 18.9 17.1 18.2 14.8 19.1 100 25.5 24.9 28.6 21.1 30.0 105 34.0 34.3 42.3 28.6 43.3 110 45.9 44.9 58.3 36.9 57.8 Source: The mortality rates give the probability (x 100) of a person aged x dying before reaching age (x+1). The figures in the Population column are based on projections provided by the Government Actuary's Department. The figures in the Annuitants column are based on the mortality tables and projected mortality improvements from the Continuous Mortality Investigation Reports No. 16 and No.

17, available from http://www.actuaries.org.uk.

Table 3: Annuity Payouts Per Year by Age and Sex, April 1999

–  –  –

Source: The data are provided by Investment Intelligence. Each entry indicates the yearly income in pounds accruing from a level policy, with no guarantee period, payable monthly in advance, and is based on a purchase price of £10,000. The rates for the joint life annuities assume that the man is the specified age (65, 70, 75) and the woman is five years younger, and there is no reduction on the first death.

–  –  –

Notes: Each entry shows the ratio of the expected present discounted value of the annuity income stream as a proportion of purchase price (£10,000). Calculations use the average annuity rate in the market and the term structure of yields on UK government bonds.

Table 5: Money’s Worth Ratios for Different Types of Annuities in April

–  –  –

Notes: Each entry shows the ratio of the expected present discounted value of the annuity income stream as a proportion of purchase price (£10,000). Calculations use the average annuity rate in the market and the term structure of yields on UK government bonds.

–  –  –

Notes: Each entry shows the ratio of the expected present discounted value of the annuity income stream as a proportion of purchase price. Calculations use the average annuity rate in the market and the term structure of yields on UK government bonds.

–  –  –

Notes: Each entry shows the ratio of the expected present discounted value of the annuity income stream as a proportion of purchase price. Calculations use the average annuity rate in the market and the term structure of yields on UK government bonds at the time. The rates are for level annuities, payable in advance, with a five year guarantee. Note that the figures are ex-post rates that make mortality improvement assumptions that were not in use when the annuities were priced.



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