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ANNUITY MARKETS:
THE CHALLENGE OF INFLATION
Dimitri Vittas
Consultant
The World Bank
FIXED NOMINAL ANNUITIES

The main rationale for life annuities is to protect retirees from outliving
their savings. Fixed nominal annuities provide protection against the
longevity and investment risks but are exposed to inflation risk.

Even a low rate of inflation of 1% per year will lower the real value of
annuity payments by 18% after 20 years. With 3% inflation, the
reduction amounts to 45% and with 5% to 62%.

The average life expectancy of retirees is between 15 and 20 years. This
implies that between one half and one third of retired workers will still
be alive 20 years after retirement. They will suffer heavily even with
moderate inflation if they buy fixed nominal annuities.

Fixed nominal annuities fail to provide effective protection.
Nevertheless, workers who have a short life expectancy or who
underestimate their longevity prefer fixed nominal annuities because
early payments are higher than with alternative annuity products.
INFLATION AND
THE DECLINE IN REAL VALUES

Rate\Years
10
20
30
10%
61%
85%
94%
5%
39%
62%
77%
3%
26%
45%
59%
1%
9%
18%
26%
0.5%
5%
9%
14%
DEALING WITH INFLATION RISK

Four broad types of annuity products address the inflation risk:
– escalating nominal annuities;
– fixed real annuities;
– “dollarized” or “euroized” annuities; and
– variable annuities.
ESCALATIING NOMINAL ANNUITIES

Escalating nominal annuities provide partial protection against inflation
risk. This depends on the rate of escalation (which is usually set at 3 or 5
percent) and the inflation rate.

If the rate of escalation is higher than the rate of inflation, the real value
of annuity payments increases. In contrast, escalating nominal annuities
suffer a decline in real value when the rate of inflation exceeds the rate
of escalation.

In principle, escalating annuities should appeal to people with longer life
expectancy. This creates a selection bias which providers of annuities
must take into account in their pricing and reserving policies.

Despite their attractions and simplicity, escalating annuities have not
been actively promoted and do not seem to play a significant part in any
national annuity market.
FIXED REAL ANNUITIES

Fixed real annuities provide protection against longevity, investment and
inflation risks.

They start with lower payments than nominal annuities but exceed
nominal annuity payments in later years. For this reason, they appeal to
people with longer life expectancies.

This self-selection bias explains in part the higher load charge that fixed
real annuities entail.

In the absence of inflation-linked securities, annuity providers also
charge an inflation risk premium that raises their cost.
SHORTCOMINGS OF
FIXED REAL ANNUITIES

The main disadvantage of fixed real annuities is their high cost relative
to nominal and variable annuities.

In most advanced countries, inflation-protected securities earn on
average lower real rates of return than nominal securities, corporate
equities and real estate, although their returns suffer from lower
volatility.

A second major shortcoming is that insurance companies and pension
funds assume the inflation risk. They need to have access to inflationprotected securities to be able to hedge their risks.
FIXED REAL ANNUITIES:
THE CASE OF CHILE

Chile does not authorize the use of fixed nominal annuities. For
retirees who annuitize, it mandates the use of either fixed real
annuities or variable annuities.

In 2008, 66% of all primary pensioners had an annuity and 34%
used a phased withdrawal. 90% of early retirees opted for a life
annuity, but only 36% of old age pensioners.

There was a slowdown in recent years in the growth of the annuity
market because of stricter conditions for early retirement. 20,000
new policies are issued each year, down from close to 30,000 before
2004, for a total premium of 50 million UFs.

Variable annuities were authorized in 2004, in combination with
fixed real annuities, but there has been little activity.
FIXED REAL ANNUITIES:
THE CASE OF CHILE II

In Chile there is ample supply of medium- to long-term inflation
instruments, including government, corporate and mortgage bonds.
However, inflation bonds with maturities of over 20 years are not
widely available.

Thus, annuity providers suffer from a duration mismatch between
their assets and liabilities. This is estimated at around 4 years.

A new electronic quotation system was introduced in 2004 to
improve the marketing of annuities and lower costs. Annuity
commissions have fallen to 1.5%. They exceeded 6% in the 1990s.
FIXED REAL ANNUITIES:
THE CASE OF CHILE III

Annuitants appear to be getting a good deal, although declining real
interest rates have caused a significant fall in annuity conversion
factors.

The Money’s Worth Ratio (MWR) for joint life annuities was
calculated at 108% in March 2005, using the government bond yield
curve. This fell to 89% when the corporate bond yield was used.

The true level of the MWR is probably in between. The
corresponding MWRs for the UK were estimated at 88% and 78%
respectively.
REAL YIELDS ON TIPS IN US & CHILE
ANNUITY RATES & ACFs IN CHILE
9
8
7
6
US
5
Chile
4
ANR
3
ACF
2
1
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
REAL YIELDS ON TIPS IN US & CHILE
ANNUITY RATES & ACFs IN CHILE
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
US
REAL % REAL %
3.95
6.51
4.15
6.38
3.47
5.27
3.25
4.11
2.14
3.93
1.95
3.51
1.77
2.55
2.26
2.98
2.56
2.90
1.51
3.24
CHILE
ANR
5.52
5.58
5.45
5.11
4.23
3.33
3.30
3.55
3.27
3.59
ACF
8.28
8.23
8.13
7.94
7.31
6.75
6.40
6.42
6.20
6.29
REAL INTERST RATES AND
ANNUITY CONVERSION FACTORS
Rate\Years
15
20
25
5%
9.6%
8.0%
7.1%
3%
8.2%
6.7%
5.7%
1.5%
7.5%
5.8%
4.8%
0%
6.7%
5.0%
4.0%
ROLE OF INFLATION BONDS:
MOST OTHER COUNTRIES

In most other countries, the main provider of inflation bonds is the
government.

The supply of such bonds has increased in recent years, but even so it
would be wholly inadequate if the demand for fixed real annuities were
to take off in other countries as it has done in Chile.

Thus, in addition to being expensive, inflation bonds are also in short
supply.

Getting the government to issue more of these bonds would imply heavy
reliance on the government for ensuring that the private pension system
delivers on its promises.
“DOLLARIZED” OR
“EUROIZED” ANNUITIES

These are annuities that are linked to a stronger and more stable foreign
currency, like the US dollar or the euro.

They protect against runaway inflation and large currency depreciation
in small, poorly managed, economies.

But unless they are linked to inflation-protected instruments they fail to
provide effective protection, especially over the long run.

US inflation averaged more than 3% per year over the past 30 years.
VARIABLE ANNUITIES

The main attraction of variable annuities is that they enable retirees to participate
in the normally higher investment returns of equities, real estate and
commodities.

Their main weakness is that pensioners assume the investment and inflation
risks.

With variable annuities, annuitants also usually share in the longevity risk. This
is not a disadvantage but a different way of coping with this risk.

Variable annuities require a robust system of regulation and supervision and a
high level of transparency and integrity on the part of annuity providers.
TYPES OF VARIABLE ANNUITIES

Variable annuities take two main forms: profit participating; and unit-linked.

The first type allows for some smoothing of returns. They often take the form of
“guarantee and bonus” annuities, combining guaranteed minimum benefits with
annual bonuses that target the preservation of the real value of annuity payments.

In unit-linked annuities, the investment risk is borne by annuitants. They are
often offered with caps and floors on their returns which lower their exposure to
the high volatility of equity returns.

Unit-linked annuities are more transparent than profit-participating annuities.
THE REGULATION
OF VARIABLE ANNUITIES

Variable annuities require a sophisticated system of regulation and
supervision.

Clear rules should be adopted for the initial calculation of annuity
payments and their annual adjustment in the light of net investment
returns, inflation, longevity experience, and operating costs.

The rules should specify the principles that would need to be observed in
the creation of sound reserves and the distribution of profits between
policyholders (annuitants) and shareholders.
THE MARKETING
OF VARIABLE ANNUITIES

The marketing of variable annuities would also need to be tightly
regulated to prevent mis-selling and other deceptive practices.

A central register comparing and publicizing the performance of
different providers on a consistent and meaningful basis should be
established.

The example of Chile in setting up a centralized electronic quotation
system would merit detailed consideration. This lowers search costs,
minimizes the influence of brokers, and promotes greater transparency
and competition.

The same entity could combine the two tasks of centralizing quotations
and comparing performance.
VARIABLE ANNUITIES
IN DENMARK AND SWEDEN

Variable annuities of the “guarantee and bonus” type are widely used in
Denmark and Sweden. Recent years have seen significant growth in
unit-linked annuities with some guarantees.

The regulation and supervision of variable annuities appears to be robust
in these two countries. It is in principle based on transparency, adequate
reserving and strong competition among providers.

A major part of the market is based on collective labor agreements,
which favor defined-contribution plans and encourage the use of
variable annuities, including both life and term annuities.

Involvement of two large state entities, ATP in Denmark and PPM in
Sweden, is having an impact on the market.

However, there is no readily accessible compilation of data on the
performance of variable annuities.
CONCLUDING REMARKS

Most annuity products suffer from important shortcomings.

Some are exposed to investment and inflation risk, others only to
inflation risk, others to fixed low returns.

All annuity products suffer from liquidity risk, while fixed products are
also exposed to annuitization risk.

The best way to handle all these risks is to promote a combination of
payout options.
COMBINATION
OF PAYOUT OPTIONS

The combination of payout options should require the use of a minimum
level of fixed real annuities. In many countries, this would be provided
by the first pillar. In Chile, this is equal to the Minimum Pension
Guarantee.

For additional levels of annuitization, retirees should be free to choose
between fixed real annuities, escalating, annuities, variable annuities,
phased withdrawals and even self-annuitization.

Lump sums and self-annuitization could play a significant part, provided
retirees are also required to purchase deferred annuities that would
generate in older age an adequate supplement to the income from the
first annuity.

FIXED NOMINAL ANNUITIES SHOULD BE BANNED!