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Impact Investing

IPE special report May 2018


Tackling annuitisation issues

Developing an Annuity Market in Europe
Edited by Elsa Fornero & Elisa Luciano
ISBN 1 84376 476 8
320 pages hardback
Price £69.95
Edward Elgar Publishing

This book is a collection of the papers presented at the third annual conference of CERP (Centre for Research on Pensions and Welfare Policies, Turin) in June 2002. The papers explore various characteristics of annuities and annuity markets, and their role in several countries at different stages of development. The issues covered are important and timely. The reduction in state pension benefits underway in much of continental Europe along with the shift from defined benefit to defined contribution schemes in those countries with large funded private sector schemes means that the potential role for annuities is set to increase substantially.
For those without the time or energy to read the whole book, the introduction by Elsa Fornero and Elisa Luciano, professors, respectively, of economics and mathematical finance at the University of Turin, provides a very good overview of the papers contained in the book and of the key themes to emerge from them. As the summary indicates the book does not so much provide answers to the many puzzles about annuity markets as clarify the issues and offer some useful insights. The papers that follow represent in the field of annuities a ‘who’s who’ of leading academics in the US and Europe.
The opening paper (McCarthy and Mitchell) tackles several of the key issues starting with ‘Is longevity insurance a good deal?’.The analysis and supporting data across several major economies suggest that generally annuities offer good value and are ‘wealth enhancing’ even for those with substantial social security and pension income benefits. Demand and supply side issues are described in terms accessible to a reader without technical expertise.
E Philip Davis then considers regulation of annuities markets. He explains why the ‘free market’ cannot just be left to its own devices and outlines approaches to prudential regulation which address security of supply. He then moves on to conduct of business regulation, raising the particular problem confronting the UK consumer of a ‘plethora of choices’. Finally he explains the regulation of annuities in the context of a pension system. Particularly thought provoking is the section on longer-term risk, aspects of which are unexpected longevity improvement and credit risk on bonds.
Soares and Warshawsky explore risks to which annuitants are exposed. They produce US data for annuity volatility from 1983 to 2002 and findings as to the extent that spreading purchases instead of buying at a single point in time reduces volatility. The relationships are presented in a number of useful graphs.
Hurd, Panis, Smith and Zissimopoulos explore using data from the US Health and Retirement study variations in voluntary annuitisation rates for those taking benefits from US DC plans. This provides a fascinating insight into what might happen as the UK moves towards reduced compulsion. The findings include a low overall rate of annuitisation – typically less than 10% – and some that appear to contradict a life-cycle theory of consumption, for example lower annuitisation among the unmarried and those reporting good health. A new theoretical structure is proposed to replace the life cycle model.
The theory behind longevity risk – probably the key issue for annuities – is given a very clear exposition by Pitacco using diagrams to illustrate what would otherwise be very complex mathematical concepts. He brings out the core distinction between risk that can be reduced through pooling (random fluctuations around central values) and systematic risk where the position of the central values is wrongly estimated and so increased pooling aggravates the error. This problem is explored with the aid of models. Finally there is a summary of various paths towards annuitisation and the sharing of risks between providers and pensioners implied by them.
Ballotta and Haberman supply the most technically complex paper on guaranteed annuity options. Such options to buy annuities on pre-determined rates were features of some UK pension contracts. Falling interest rates and greater longevity are shown to have generated sharply increasing ‘in the money’ option values in recent years, and the results offer a warning for those contemplating provision of such options.
The key questions addressed by Cannon and Tonks for the UK are whether the fall in annuity rates is greater than can be justified by changes in interest rates and mortality, and whether the fall has reduced the ‘replacement ratio’ (income after/income before retirement). The answer on both counts using published annuity prices appears to be no. ‘Money’s worth’ for annuities appears to be almost too good and to the date of the paper investment performance has tended to offset the effect of falling annuity rates.
A final batch of papers considers annuity markets in Germany (Schnabel), Switzerland (Butler) and Italy (Borella, Fornero and Ponzetto). The recent Riester reform in Germany is described and represents a major experiment in choice between pension vehicles which in turn operate with varying obligations to annuitise. Tax breaks by pension vehicle in Germany are broadly correlated with that obligation. Switzerland has a much more mature annuity market, with a majority of those retiring from the mandatory employer schemes choosing to annuitise despite freedom to take all benefits in lump sum form and tax incentives for so doing. Part of the explanation appears to be very generous mandated annuity rates that are contributing towards a financial crisis in a pension system that has not fully adjusted to lower interest rates and increased longevity. Italy has an immature funded pensions market growing very slowly in the context of a particularly generous state benefits system. There is compulsory annuitisation and some data analysis suggests a greater demand for products that will require annuitisation among those less well provided for by state benefits.
This book is rather more about annuitisation issues in general than about developing an annuity market in Europe but is nevertheless of substantial interest. Those wishing to grow their knowledge of this subject will find it very useful.
Mike Wadsworth is a partner with Watson Wyatt

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