Private Pension Annuities in Chile

Studies | Social Security

No. 271
Thursday, December 09, 2004
by Estelle James


Why Do the Majority of Retirees Annuitize?

Table IV - Total Number of Policies by Type of Benefit%2C 1983-2002

“Regulations encourage workers to purchase annuities.”

A key choice that retirees must make is whether to choose programmed withdrawals or annuities. Policymakers have an interest in this decision, since annuities are most likely to provide a steady stream of retirement income, which is a major aim of the social security system. Annuitization also reduces the liability that the government incurs through the minimum pension guarantee. Chile did not mandate annuitization, in part because of political opposition and in part to accommodate divergent interests among workers, some of whom may expect to die young. However, as mentioned earlier, two-thirds of all retirees do annuitize. Why this large percentage, which is far greater than in any other country? What lessons can other countries draw from this behavior? The high annuitization rate is likely due to six major factors:

  • The demand for longevity and investment insurance and the absence of defined benefit plans or other institutions that provide such insurance;
  • Regulations that constrain individual choice;
  • Regulations that give insurance companies selling annuities a competitive advantage over pension fund administrators selling programmed withdrawals;
  • The linkage between early retirement and annuitization;
  • Marketing activities by insurance companies, exploiting that linkage; and Competition, which forces insurance companies to offer good terms — a high money’s worth ratio — to retiring workers.

We will discuss each of these factors in turn.

“The government guarantees poverty-level benefits.”

Longevity and Investment Insurance. When Chile’s new individual account system was adopted, it totally replaced a government-provided defined benefit plan that provided a lifetime pension. For workers who switched and for new entrants to the system, the public treasury no longer provided a benefit that insured against outliving their retirement savings or a fall in the value of their savings (that is, longevity and investment insurance). Very few employers in Chile provide such plans privately to their employees. Therefore, retirees who wish to ensure that they will not outlive their retirement savings must purchase an annuity. Adverse selection based on expected longevity, much discussed in the insurance literature, does not seem to dissuade them.

The one remaining type of defined benefit is the minimum pension guarantee, which provides longevity and investment insurance that is especially relevant to pensioners with small accumulations. Consider a worker whose initial programmed withdrawal pension is just slightly above the guaranteed level. The minimum pension guarantee sets a floor to the monthly income of this worker. Once his pension reaches that level, it cannot fall below. Instead, he must continue to withdraw his monthly pension at that level until his savings are used up, after which the government pays the pension for the rest of his life. Since the minimum pension guarantee provides longevity and investment insurance to such workers, they do not need to purchase annuities for this purpose. In contrast, workers with large accumulations must suffer a steep decline in their monthly pension before reaching the pension floor. If they don’t want to bear this risk, they must annuitize to get a stable lifetime income flow. We would therefore expect retirees with small accumulations to take programmed withdrawals while those with large accumulations would annuitize. But those with the largest accumulations might also choose programmed withdrawals, because they are willing and able to accept the longevity risk in order to get the higher expected return from programmed withdrawals and retain investment control plus bequest rights.

“Preretirement withdrawals are not allowed.”

In fact, this is exactly what has happened. Most workers who retire at the normal age have small accumulations that yield pensions in the neighborhood of the guaranteed amount, and two-thirds of these take programmed withdrawals. In contrast, the one-third who annuitize have an accumulation and average pension that is almost twice as large. Early retirees have much larger accumulations than normal age retirees, and 85 percent of them have purchased annuities. Retirees with large accumulations are much more likely to annuitize, because of their demand for insurance (against outliving their assets and the risk inherent in stock and bond investments) and the absence of other insurance alternatives. But the small group of early retirees with the largest accumulations choose programmed withdrawals. [See Appendix Tables II, III and IV.] This divergent behavior underscores the crowd-out effect on private annuity insurance that stems from publicly provided insurance. Without the minimum pension guarantee, it is likely that more workers with small accumulations would have annuitized, to acquire longevity and investment insurance.

Regulations that Constrain Individual Choice. As discussed above, Chile severely restricts the choice of payout. Lump-sum withdrawals are generally not permitted, nor are preretirement withdrawals allowed for housing, education or other purposes. This contrasts with other countries where lump-sum or fixed-period payouts are permitted (for example, Australia) or where funds can be withdrawn for housing (as in Singapore).18 In Chile, a person must meet the conditions for retiring and receive the money gradually, either through an annuity or programmed withdrawals.

Programmed withdrawals offer certain advantages to workers. They allow retirees to:

  • Choose the investment strategy — choice of pension fund administrator and portfolio. Until 2003, each administrator could offer only one portfolio and all had similar investment strategies, but regulations now allow greater variety. This enables programmed withdrawal pensioners to invest in a riskier portfolio with a higher expected return than annuities.
  • Get their money out of the system quickly. During the first few years of retirement, the programmed withdrawal formula produces payouts that exceed annuity payouts, and then vice versa, due to the required mortality and interest rate assumptions.
  • Be sure that they and their heirs will receive back the full value of their accumulation, regardless of when they die (since they leave a bequest to their heirs if they die early).
  • Switch to an annuity, if desired, later on, whereas the choice of an annuity is irreversible.
Figure IV - Level Annuity Compared with Programmed Withdrawals

These advantages might make the programmed withdrawal option very attractive to retiring workers. But it has one big disadvantage: it does not provide investment and longevity insurance beyond the minimum pension guarantee.

“The income of retirees who withdraw funds declines over time.”

In the first year, the programmed withdrawal formula is exactly the same as the formula for an actuarially fair annuity; that is, if insurance companies and fund administrators assume the same future interest rates and mortality tables, annuities and programmed withdrawals will yield the same pension in the first year. However, a fixed-rate annuity payout remains constant, while the programmed withdrawal payout is recalculated every year. The programmed withdrawal will decline in the second year, because the expected life span increases for pensioners who have survived an additional year, and so on for successive years. [See Figure IV.] Additionally, regulations lead fund administrators selling programmed withdrawal pensions to assume higher mortality rates and higher rates of return than insurance companies selling annuities. This enables them to pay more in the first few years, but much less later on. Monthly payouts fall over time and will eventually become very small, in contrast to the level annuity. They fall even faster if investment earnings decline. This should deter risk-averse workers from choosing programmed withdrawals, except for those with small accumulations, who receive protection from a falling payout from the minimum pension guarantee. In any event, with the range of payout options so limited, and with gradual withdrawals required, annuitization becomes a more likely choice than it would be in a less constrained environment.

Regulatory Advantages to Insurance Companies. Insurance companies selling annuities have a competitive edge over fund administrators selling programmed withdrawal pensions. First of all, insurance companies are allowed to pay sales commissions to independent brokers, while account managers are not. Hence, workers who visit or are visited by a financial adviser to explore their options (as many do) are likely to be steered toward insurance companies and annuities. Since commissions are usually a function of premium size, brokers will be most interested in marketing to retirees with large accumulations.

Further, the differences in regulations governing fees are likely to lead pensioners to choose annuities sold by insurance companies rather than programmed withdrawal pensions sold by fund administrators, and to make the fund administrators prefer active workers over pensioners as clients. All fees charged by fund administrators must be explicit, and they are not permitted to sign long-term contracts binding these fees. The entire investment return must be passed on to the owner of the account. Although pensioners have large assets compared with workers, fund administrators cannot charge asset-based fees, and cannot charge any fee at all for pensioners receiving the minimum guarantee from the government, although this is the highest cost group to administer. The largest revenue source for pension fund administrators is fees based on contributions (which are made mainly by workers, not pensioners).

In contrast, insurance companies are not permitted to charge explicit fees for annuities. Instead, they can only quote a monthly payout and must cover their costs and profits from the “spread” — the difference between the present value of this payout and the premium that is paid. In effect, the “price” of the annuity is hidden, and the retiree may not even be aware that there is any fee. Annuity payouts are obliged to remain stable regardless of how insurance company costs and spread change, while pension fund administrators’ fees may change in the future in ways that diminish pensions.

“The early retirement option encourages workers to purchase annuities.”

Early Retirement and Its Link to Annuitization. Early retirement — before age 65 for men and age 60 for women — poses the danger that many early retirees will have low incomes in very old age, especially if they choose programmed withdrawals. If they become eligible for the minimum benefit, there is a potential cost to the treasury. However, in Chile early retirement has become the lure for workers to annuitize, greatly mitigating these dangers. The net result is that a majority (60 percent) of pensioners have retired early and an overwhelming proportion of early retirees (85 percent) have annuitized. [See Appendix Tables II, III and IV.] Among annuitants, early retirees outnumber normal age retirees by almost 4 to 1. Thus, early retirement and annuitization are inextricably linked.

The conditions for early retirement were stringent at the beginning of the new system, but were loosened during the 1980s. Initially early retirement was allowed only if the worker could acquire a pension that was 100 percent of the pension guarantee and 70 percent of his own average wage over the past 10 years — a condition that was difficult to meet. However, in 1987 the required replacement rate was reduced to 50 percent of a worker’s own wage but the pension guarantee requirement was increased to 110 percent. In making this calculation, nominal wages from the past are price indexed and months without wages are averaged in as 0s, so unemployment (whether voluntary or involuntary) helps a worker to qualify. Also, starting in 1987 employers who wished to facilitate a worker’s early retirement could put extra money into his retirement account. And workers were allowed to sell to insurance companies the recognition bonds (bonos de reconocimiento) that they had received in return for their contributions to Chile’s old system prior to 1981. These bonos became part of the premium for an early retirement annuity. In contrast, pension fund administrators could not buy bonos until 1990, which greatly hampered their ability to compete in the early retirement market.

“Insurance companies actively compete for business.”

How Workers Learn They’re Eligible: Marketing by Insurance Companies. Given this potential market and the competitive edge provided by regulations, insurance companies and brokers eagerly seized the opportunity to identify clients, lure them away from the funds where they were contributing workers, and sell them early retirement annuities. Eligibility was complicated to determine, but insurance salesmen figured this out and promptly informed qualifying workers. According to anecdotal evidence, some brokers made loans to workers to put into their personal accounts, thereby enabling them to meet the eligibility criteria faster. Insurance companies and brokers handled the paperwork, bought the bono early and calculated the maximum allowable lump sum withdrawal.19 It is widely believed that sales commissions were shared with new annuitants as unofficial rebates. Of course, when they sold early retirement, they also sold annuities. They focused their attention on workers with large accumulations, who were more likely to meet the eligibility conditions and would also yield a higher commission to brokers and larger profits to insurance companies. As a result, as noted above, early retirees have larger pensions than normal age retirees and are highly likely to annuitize.20

In contrast, fund administrators could not pay commissions to independent brokers and did not actively market programmed withdrawal pensions. They got higher fees if affiliated workers remained contributors rather than becoming retirees. Marketing costs are sometimes disparaged as a payoff to aggressive salespersons in a zero- or negative-sum game. However, in this case marketing by insurance companies provided useful information about the early retirement regulations set by government and pushed retirees in the direction of annuitization, which minimizes risk for government and pensioners.

Table V - Money's Worth Ratios%2C Chile

“Annuities give workers a high return on their investment.”

The High Money’s Worth Ratio of Price-Indexed Annuities. A final reason for the high rate of annuitization in Chile is the high return on investment, or money’s worth ratio, that annuitants receive. When an annuity premium is paid in, it is gradually returned to the annuitant over his or her expected lifetime. The money’s worth ratio is the present value of the entire lifetime income stream that an annuitant expects to receive, divided by the initial premium.21 If the ratio is 100 percent, this means that consumers can expect to get back all the money they paid in, in addition to interest plus longevity and investment insurance. If it is considerably less than 100 percent, consumers are getting back a lot less than they put in and they may not purchase the annuity. If it is much greater than 100 percent, insurance companies may be offering too much in order to gain market share in the short run and may not be able to keep their promises in the long run. In Chile, the money’s worth ratio is close to 100 percent.

To make this computation, we surveyed several insurance companies in March 1999 and again in March 2003 and computed the average payout each year for several different annuity products. Since annuities involve payouts far into the future, it is necessary to discount the income stream, and the present value is very sensitive to the discount rate chosen. We therefore used two alternative discount rates: a low risk-free (government bond) discount rate and a higher-risk investment discount rate.22

“On the average, retirees get back all the money they put into the system.”

It is also necessary to take into account the expected lifetime of the annuitant, based on mortality tables. We used two different mortality tables in our analysis: a 1985 mortality table, which is used by regulators but probably understates longevity, and a 1998 table based on more recent data, with lower mortality, which is not yet used officially but is probably closer to the truth.

Using the 1998 mortality table and the risk-free discount rate, we found that the money’s worth ratio for a 65-year-old male is 98 percent. This means that the typical annuitant gets back almost the full premium over his lifetime, in addition to the risk-free interest rate and insurance. The ratio is 5 to 10 percent lower when the 1985 mortality table or the risky discount rate are used. People whose mortality is represented by this high mortality table (perhaps because they are poor or in ill health) are unlikely to recoup their full premium and may be better off choosing programmed withdrawal — which may be one reason why workers with small accumulations choose that option. Workers who prefer a riskier investment with higher expected returns may discount at the higher rate and decide they are better off choosing their own investment strategy under programmed withdrawal. But the average worker whose longevity is represented by the 1998 table and who wants a safe retirement income gets a very good deal in the Chilean annuity market. Annuity payouts declined 15 to 20 percent between 1999 and 2003 due to falling interest rates, but, as Table V shows, the money’s worth ratio did not fall.

Table VI - Rate of Return on Annuities%2C Programmed Withdrawals and Insurance Company Investments%2C 1993-2002

“Annuities are adjusted for inflation.”

Money’s worth ratios in the neighborhood of 100 percent have been found in many other countries, as well. However, annuities in other countries are usually not inflation-adjusted, and for price-indexed annuities the ratio is considerably less than 100 percent. Insurance companies are usually reluctant to offer price-indexed annuities because indexed investment instruments with which to hedge this risk are not available or pay a low rate of return. Also, if indexation is voluntary, it is more likely to be chosen by retirees with greater expected longevity — adding to their expected cost. For these reasons, if insurance companies do offer indexed annuities, they impose a high price in the form of a low money’s worth ratio. For example, the money’s worth ratio that annuitants receive for indexed annuities is 89 percent in the United Kingdom compared with 98 percent for nominal annuities.23 In Chile annuitants get a 98 percent return for indexed annuities. Indexed annuities provide a better return in Chile because insurance companies have a choice among many inflation-indexed investment instruments and because indexation is mandated, hence it does not cause adverse selection as it might in the voluntary market. The fact that annuities are inflation-proof in Chile makes the high money’s worth ratio especially impressive and makes annuities especially attractive to retirees.24

“Insurance companies operate on a small margin between earnings and payouts.”

Importance of the “Spread.” How do insurance companies manage to cover their costs and profits while repaying the full premium and providing longevity and investment insurance to annuitants? Their earnings come from the difference between the risk-free rate that they pay annuitants and the risky rate that they earn on the diversified portfolios in which they invest the premiums.25 These portfolios include long-term public and corporate bonds, mortgage-backed securities and some equities. The insurance companies reduce the risk inherent in these securities by a variety of techniques such as investment diversification, use of derivatives, reinsurance, negative correlations among product lines, keeping reserves that exceed liabilities, using shareholder net worth as buffers, and, ultimately, government guarantees. To a limited extent they also invest in long-term instruments whose rates have not fallen nearly as much as short-term rates, while covering short-term payouts out of cash inflows. In addition, insurance companies earn a premium owing to their capacity to invest in illiquid instruments. As a result of these measures, the spread between the rates paid and earned in Chile has historically exceeded 1.4 percent per year, which is enough to cover their costs. [See Table VI and Figure V.] It remains to be seen whether this spread and the high money’s worth ratio it supports can be maintained in the future, as interest rates fall.

Figure V - Rate of Return to Insurance Companies and Annuitants

“Annuities do not appeal just to people who expect long lives.”

Do Workers with Poor Health Opt Out of the Annuity Market? If insurance companies expect annuities to be purchased predominantly by people with good health, they will set their payouts accordingly, which will lead to bad terms for people with poor health, who consequently will not purchase annuities. This could lead to a breakdown of the annuity market through the well-known process of adverse selection. This is sometimes used as a rationale for a public defined benefit plan or for compulsory annuitization under a private defined contribution plan. Data from Chile throw some light on this question.

First of all, with such a high rate of annuitization, it is clear that the market has not broken down, and that annuities do not appeal only to a small group of healthy people. This is due in large part to the regulations described above and to the marketing activities of insurance companies. The joint annuity requirement further reduces potential adverse selection because the expected lifetimes of both spouses, which are not perfectly correlated, will be taken into account. Insurance companies in other lines of business reduce adverse selection by putting customers into different risk categories and pricing differentially according to their expected risk. Family background, DNA and health examinations could be used for this purpose in the annuity market — but this does not seem to happen in Chile. However, gender-specific mortality tables are used in Chile, thereby avoiding adverse selection based on gender.

We could not compare the mortality rates of retirees who chose programmed withdrawals versus those who chose annuities, since we did not have mortality information on programmed withdrawal pensioners. However, we do have information about mortality rates of annuitants, which enabled us to compare the actual death rate with the expected death rate of various sub-groups based on population mortality tables. Our findings, as summarized in Table VII, show that:

Table VII - Ratio of Actual to Expected Deaths by Annuity Type and Premium Size%2C Males%2C 1990-2001
  • The ratio between actual and expected mortality rates of annuitants was relatively low shortly after they retired, but grew sharply in the medium term. This suggests that retirees who know they are in bad health and likely to die soon are less likely to purchase annuities, but this effect of private information is concentrated in the first two to three years after retirement; after that mortality stabilizes near the expected level for the population.
  • The ratio between actual and expected deaths was higher for retirees who purchased annuities with a guaranteed payout period (such as 10 or 15 years) rather than a simple annuity. This suggests that workers who suspect they are in ill health may still purchase annuities, but they choose an annuity product that continues the payment to their heirs.
  • Annuitants with higher premiums have lower ratios of actual to expected deaths, which is consistent with the correlation between wealth and longevity that has been noted in other cases. However, insurance companies do not use this information to give them inferior terms — and in fact seem anxious to market to this group — perhaps because they get access to larger assets on which to earn the spread and because the lower administrative cost per dollar of premium offsets the greater longevity due to economies of scale.

“Most people cannot accurately predict when they will die.”

Thus, some selection according to private information seems to exist, but mainly about short-run mortality probabilities, and it does not lead to a breakdown of the annuities industry. Retirees who want the insurance that annuities provide but suspect they will die young can choose an annuity product (such as annuities with guaranteed payment periods) that does not penalize those with short lifetimes. It is important for regulators to allow product variety to keep these people in the market. Retirees with small accumulations are more likely to have shorter lifetimes and are less likely to annuitize — but the minimum pension guarantee is the most obvious explanation for this behavior. Overall, these facts suggest that asymmetric information is not a major source of adverse selection nor does it have a large impact on size of the annuities market in Chile.26


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