Social Security and Market Risk
Tuesday, July 31, 2001
by Liqun Liu, Andrew J. Rettenmaier, and Zijun Wang
Table of Contents
The Annuity Market: Present and Future
Social Security currently provides insurance against the risk of outliving one's savings. To insure against this risk, a private retirement system based on individual retirement accounts must convert the funds into annuities upon retirement. Since the purpose of personal retirement accounts is to allow workers to prepay part of their scheduled Social Security benefits, the annuity payments would offset those benefits in part. Our primary interest is in the single premium immediate annuity, which provides a fixed monthly income for the life of the purchaser.
"A private retirement system must convert individual retirement accounts to annuities upon retirement."
Inefficiencies in the Annuity Market. A current disadvantage of private annuities, as opposed to Social Security, is their considerable overhead costs and inefficiency due to a lack of competition and the presence of "adverse selection" - that is, a high percentage of people who buy annuities now tend to live longer than average, which is adverse to the insurer. Economists James Poterba and Mark Warshawsky have shown that for a typical annuity today, the present value - the dollar value of expected future benefits discounted for the time one must wait to receive them - is about 85 percent of the initial premium, with the remaining 15 percent going to profits, costs of adverse selection and overhead, including administrative and marketing costs.8 This means that for every dollar one puts into the annuity market, he or she can only get back 85 cents. This low money's worth ratio - the cost compared to the present value of expected future benefits - has led some observers to conclude that the annuity market cannot be relied upon as part of a Social Security privatization plan.
However, if personal retirement accounts become a part of Social Security, it is likely that the currently underdeveloped annuity market will gain in efficiency and the costs of annuitizing retirement payouts from individual accounts will fall substantially. Adverse selection will not be a problem if everyone is required to buy an annuity. Further, overhead costs would be spread over a much larger number of accounts. Even without the impetus of personal retirement accounts, the payout value per premium dollar of annuities rose by roughly eight percentage points between 1985 and 1995, as the annuity market expanded due to an increasing number of employers switching from traditional defined benefit pension plans to defined contribution plans such as 401(k)s.9
Reasons Why the Market for Individual Life Annuities Is Small. The sales volume of single-premium immediate annuities remains small.10 Several reasons have been cited by researchers. First, the individual life annuity market is being crowded out by both Social Security and private group annuities such as corporate pension plans. Due to the inefficiencies mentioned above, the rate of return one expects from an annuity purchase is significantly lower than what the average market investment can offer. As a result, one would only want to buy a minimum annuity offering a subsistence level of benefits, but Social Security and group pensions already take care of that.
Second, there is not much wealth left for annuitization for most elderly Americans. Perhaps due to a wrong expectation of what Social Security can offer, many low- and middle- income seniors have little wealth (except housing wealth) left for annuitization, and Social Security paychecks are their primary source of income after retirement.
"The sales volume of annuities remains small, but can be expected to grow."
Third, prices of annuity products tend to be too high because of the inefficiencies associated with the market. Ironically, most of those inefficiencies come from the fact that the annuity market is currently very small. For example, overhead costs per policy are inversely related to the size of the customer pool; the smaller the pool size, the higher the price. Moreover, a very small demand often fails to provide sufficient incentives for providers to engage in fierce competition; as a result the annuity market tends to be less than competitive and annuity prices tend to be high. Most importantly, since there are relatively few buyers, all of whom voluntarily select into the market, they tend to live longer than average. Since annuity companies do not have perfect information about buyers' longevity, they must price their products according to this higher-than-average longevity. This is the adverse selection problem.
Fourth, the variety of annuity products currently available in the United States is limited. This may also be related to the small size of the market. For example, although the single-premium immediate annuities closely parallel current Social Security benefit payments, most annuities currently available in the United States are not indexed for inflation. Thus, there is limited protection against inflation risk. Additionally, few annuity companies offer significant discounts to customers with shorter life expectancy, such as individuals who can demonstrate a long-term smoking habit.
Personal Retirement Accounts and the Future of the Annuity Market. The fact that the annuity market is not heavily used for longevity insurance and retirement income today does not necessarily mean it cannot be relied on in the future as part of a new retirement system featuring personal retirement accounts. As Social Security benefits are replaced fully or partially with proceeds from personal retirement accounts, the demand for individual life annuities will increase dramatically, as will the efficiencies of the annuity market and the variety and quality of annuities.
With a dramatic increase in annuity demand from Social Security privatization and increased senior wealth in the form of tax-deferred retirement accounts in the future, annuity company overhead is expected to fall on a per policy basis. Competition among annuity providers will increase and, as has happened in the United Kingdom since its public pension system was partially prefunded with personal retirement accounts, annuities with inflation-indexed payments will eventually be available.
Most importantly, the cost of adverse selection will be lowered significantly. Economist Olivia Mitchell and her colleagues have found that about two-thirds of the disparity between an annuity premium and its money's worth in terms of the expected present value of its future payouts can be explained by adverse selection.11 With mandatory and increased voluntary enrollments into annuity policies, the money's worth ratio of annuity purchases is likely to increase from 85 percent to 90 percent, even assuming the adverse selection would only be half as important in the future as it is now. With improvement in competition and reduction in overhead expenses, it is reasonable to expect that the money's worth ratio for annuity purchases could reach 95 percent or above.
"The abilitiy of a private retirement system to provide longevity insurance hinges on the efficiency of the annuity market."
One question is whether annuities should be mandatory. Many argue that at least a portion of the balances in personal retirement accounts should be annuitized to guarantee a certain minimum level of benefits, with the rest left to individuals' decisions. The ability of a private retirement system to provide longevity insurance hinges on the efficiency of the annuity market. Without access to annuities, consumers who have arranged their after-retirement resources based on their expectations about longevity may find themselves without sufficient resources if they live longer than expected.