Regulations overhaul plans
Hungary is drafting legislation to prepare for the paying of annuities. József Banyár and Mihály Erdos explain the challenges involved in the process
Hungary 's pension reform is about to enter a new stage. The private pension system was launched in 1998, and although there are rules for the payout phase in the existing regulation, most of the focus has been on the accumulation period.
The system foresaw that at retirement those participating in the second pillar would be able to take their accumulated pensions savings as a lump sum. So neither regulations nor the second pillar institutions were prepared for the provision of annuities.
However, under the current legislation, from 1 January 2013, people who have been members of a private pension funds, known locally as pension casses, for at least 15 years will be obliged to convert their savings into a life annuity. Until then, lump sum payments will continue.
The pension casses are special institutions since, by definition, they do not have separate capital. This is logical in a certain sense, given that neither do they have real owners. Formally, the clients are the owners but this is only the legal construction and in reality the owners are the sponsoring companies.
In the absence of solvency capital it is not seen as advisable for them to sell products containing insurance - that is, biometric - risks, or at least those types of products that provide guarantees for a client.
Consequently, there are two possibilities for future developments. First, private pension casses could be transformed into ‘normal' financial institutions with real owners and capital. Such new institutions would be capable of providing annuities. Second, the provision of annuities could be restricted to life insurers, with casses excluded from the annuity market. While life insurers already have the right to provide them, currently no institution does so.
Proposals for both options have been drafted, as has a combination where casses could voluntarily switch to being a normal financial institution while a prohibition against providing annuities is retained for those that remain a casse.
The current annuity regulation sets rules, but they are neither complete nor consistent. There is a consensus that for social and political reasons it would be impossible in practice not to adopt a compulsory unisex approach when providing annuities, even though from a demographic point of view it would be advisable to use gender-differentiated mortality tables.
An even bigger problem is posed by the compulsory use of so-called ‘Swiss indexation', which combines links both to inflation and incomes and is used in the first pillar PAYG pension system. While regulators would like to see consistent indexation between the two pillars, this is only achievable at enormous cost. The main objections are the different logic of indexation within the two pillars and the present, and probably future, lack of investment instruments capable of providing Swiss indexation. But the abolition of Swiss indexation would raise the question of indexation in general.
Currently there are two possible solutions, to which quite different additional rules can be attached:
First, is indexation to the consumer price index (CPI). This is possible only if the government is able and willing to issue long-term inflation-linked bonds in the required quantity. This currently seems to be a theoretical but not a practical possibility.
Second is indexation based on the investment return, which is similar to the method used for traditional (non-universal) life insurance products.
From a client's point of view, the main difference between the two is that a CPI-linked annuity will increase according to an index independent of the provider, while the second option leaves the client's income depending on the annuity provider's investment performance. This leaves people with the risk of choosing an annuity provider with an indexation lower than its competitors.
Consequently, should the regulator choose this option, it is important that client be given the possibility of switching providers during the payout phase. Such an option has several consequences for the remaining annuity rules, the most important is that standardised annuity products must be available so that switching is both easy and transparent for clients.
Such standardisation requires:Centrally determined and unified policy conditions; A restriction on possible annuity types with pre-determined parameters (with restricted variations); Centrally determined mortality tables at reserving; Centrally determined reserving rules; A centrally determined technical interest rate.
All these issues are important in their own right and at least the first three would be reasonable under different indexation methods and general regulations.
Centrally determined and unified policy conditions serve the interests of clients in general, and so fixing them helps in the areas of communication and consumer education.
Restricting the possible annuity types arises not just from a desire to standardise but because a wide choice of annuity types carries a high risk of adverse selection, and this adds to the expense of an annuity for clients. So it is advisable to restrict possible annuity types to some basic options - for example, single life and joint life annuities without a guarantee-period. Annuities with a guarantee period are quite attractive for annuitants with a shorter life expectancy, so in the first round they would be profitable for the providers of annuities with a guarantee period and would cause losses for the providers of annuities without a guarantee period.
Centrally determined mortality tables, and especially centrally determined projected mortality tables, are essential in all scenarios, so organising their collection is necessary, regardless of whether their use is compulsory or not.
A key issue about mortality tables is differentiation. The problem is particularly acute given the prohibition on gender differentiation in pricing. And while this prohibition arises only in pricing and not in reserving, differentiation in reserving is even more important if there is no differentiation in pricing. This is because, while at the pricing stage, differentiating between men and women would not be not possible. Different amounts will be deducted from the contribution when setting up the reserves. This gap would have to be financed by additional reserves from the provider.
In Hungary, we plan to introduce six centrally determined, regularly updated, projected and differentiated mortality tables for reserving. Moreover, we will produce an aggregate, unisex, projected mortality table to help pricing, although its use will not be compulsory. The tables will be differentiated according to gender and the client's highest educational qualification. This is because statistics show that the gap in life expectancy between those with only a primary school qualification and those with a university degree is wider than the gap between men and women.
Centrally determined reserving rules would ease the clearing of reserves between providers where a client switched from one to another. The compulsory use of the projected mortality tables would be a key factor here.
And the use of a centrally determined technical interest rate is almost obvious in the case of indexation based on an investment return. Our working hypothesis is that this technical interest rate would be 0%. It would be possible that in the majority cases the index would outpace the Swiss index, which would not be compulsory. Additionally, this rule would prevent an annuity from depreciation in the long run, although naturally at the cost of the level of the initial annuity. This would be more advantageous for longer-living annuitants than for those with a lower life expectancy, or for women with a university degree compared with men with only a primary school qualification.
Above all, informing clients and providing an environment where competition can flourish are important issues. To assist this we would like to set up a central, online ‘annuity exchange mechanism' where clients can easily compare the standardised products and previous investment results of the different providers.
József Banyár is an expert at the National Pensions Roundtable in Hungary and Mihály Erdos is the former chairman of the occupational pensions committee of the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS)