'The role of annuity markets in financing retireme
This is a welcome new study, which will appeal both to the general reader and to those seeking to understand the structure and valuation of annuities. Although based on US material and experience, it comes at a time when there is much debate in the UK and elsewhere about whether annuities are the best application for assets accumulated for retirement.
It begins with the definition of an annuity, which is, in simplest form, the income stream paid annually over the lifetime of an individual and terminating on death. An annuity is reverse life assurance – as those who die young subsidise those who live long. For a buyer, an annuity on his own life is a gamble on longevity versus ‘underconsumption’.
So, if the purchase of annuities is voluntary, those who purchase annuities will tend to select themselves against those who do not and on average will live longer. Selection therefore increases the cost of annuities. This is primarily why selection is generally not permitted under state provision or under defined benefit (DB) schemes because the principle of insurance would be undermined.
In a key chapter headed ‘Money’s worth of individual annuities’ the authors analyse the fairness of annuity contracts. The expected present discount value (EPDV) is a function of the amounts of the annual payments, the discount rate and mortality. Equating the EDPV to the purchase price of the annuity will show the internal discount rate, a measure of value if used carefully. The question to consider is: “Have annuities become more expensive or worse value over a period in which interest rates have fallen and mortality has reduced?”. Popular sentiment would suggest the answer to be yes, because a given sum buys so much less in terms of the initial monetary value than it did a decade ago.
The popular consensus may well be seriously mistaken. It is real value that matters. Inflation linked annuities are very much cheaper now than they were 10 years ago. Level annuities or annuities with limited price inflation are arguably still good value provided inflation remains under control in future.
There is no sign yet that the secular improvement in the mortality of annuitants has run its full course. Comparisons over time between annuity rates at a given age must allow for increasing life expectancy, to be meaningful. Regulation, tax and the supply of appropriate financial instruments of matching duration are all factors affecting the price of annuities to take into account.
The book briefly examines the UK annuity market, which is well developed, despite all the criticism we in the UK hear about pricing and lack of competitiveness. It is noted that index-linked government bonds have been available in the UK since 1981, and have been essential in backing annuities offering partial or full insulation against inflation.
The UK market is split into two segments. Tax-qualified retirement funds out of which annuities must be purchased, and a voluntary segment. Inevitably, annuities in the second segment are more expensive because of selection. But the UK market must prepare itself overall for greater capacity, because the majority of private pension provision is still in defined benefit (DB) form, in which pensions are paid out of the funds themselves and are not purchased. It will be very different in 10 or 20 years time, given the flight from DB schemes in favour of DC plans.
The supply constraints in the US annuity market are not mentioned; they might have yielded useful lessons for other countries. Nor does the book mention EU countries, other than the UK, where tax and regulatory regimes differ widely.
The important lessons from this book are, firstly, that most people in developed countries will not amass sufficient funds in their working lives to finance their retirement, let alone leave assets behind on death. There is a huge task to communicate these facts and educate the broad public.
Secondly, the insurance principle of retirement annuities must be retained to contain costs and avoid much misery in old age. In the UK, it is unlikely, therefore, that the authorities will allow much relaxation from the requirement to use accumulated retirement funds to buy annuities, for to do so would store up even greater trouble for the future.
Robert Thomas is a director of The Law Debenture Pension Trust Corporation in London