Private Pension Annuities in Chile
Table of Contents
“Assumptions about how long people will live are important.”
Despite the rapid growth of annuitization and the high money’s worth ratio available to annuitants, the pension industry in Chile faces some serious problems. These include:
- uncertainty about future interest and mortality rates,
- front-loading of the programmed withdrawals formula,
- overly easy preconditions for early retirement and
- a potentially large contingent liability for the government as a rising minimum pension guarantee conflicts with early retirement and front-loaded programmed withdrawals.
Uncertain Interest and Mortality Rates. When an insurance company issues an annuity, it is guaranteeing a lifetime investment return for the annuitant. If interest rates fall or longevity increases, the insurance company bears this risk and must cover the cost. Each insurance company makes its own assumptions and decides how much risk to bear. But competition may force it to make assumptions that are favorable to annuitants. For example, companies may assume that future investment returns will be higher so generous payouts can be promised. When interest rates were higher than they are today, annuities were sold under the assumption that these higher rates would be maintained. If interest rates stay low or fall further, insurance companies could find themselves in financial stress.
“Workers should not be allowed to withdraw their funds too quickly.”
Insurance companies also use an assumed set of mortality tables in their payout calculations. Our estimates of the money’s worth ratio were also based on an assumed mortality table — the 1998 table — which is roughly similar to that used by the industry. However, in reality no one knows for sure how long people will live in the future. A man who turns 65 in 2010 may live much longer than one who turned 65 in 1998 or 1985, due to improvements in medical technology and lifestyle in the interim. So far Chile has not built a “cohort mortality table,” such as American insurance companies have, that takes account of these projected mortality improvements (and, indeed, these projections themselves are uncertain). The insurance industry runs the danger of serious financial trouble if such tables are not built, and if annuitants outlive the expectations built into the annuity terms. In the extreme, if insurance companies cannot meet their obligations, this becomes a public liability, due to the government’s guarantee of the minimum benefit and 75 percent above that level.
Front-Loading of Programmed Withdrawals Due to Mortality and Interest Rate Assumptions. The allowable programmed withdrawals also depend heavily on the mortality table and interest rate structure used in the calculation, and these are specified by the pension fund regulator. When assumed mortality and interest rates are higher, the initial allowable programmed withdrawals payout is higher — it becomes more front-loaded. But if these are overstated, the retiree’s accumulation is used up faster than it would be otherwise. This risk of low pensions in the future due to exaggerated mortality and interest rates is passed on to workers and, eventually, to the public treasury, which must pay the minimum pension when the workers’ accounts are depleted. The pensioner gets more at first but the government pays more later on.
Currently the pension fund regulator requires use of the 1985 mortality table for programmed withdrawals. This overstates mortality rates for annuitants. The regulator argues that it may be more applicable to the programmed withdrawal population, which includes many low earners with low accumulations forced by regulations to take programmed withdrawal. However, mortality data are not available for these pensioners that would allow us (or the regulator) to test this hypothesis. If the pensioners live longer than expected, the government may be left with a large bill.
Interest rate assumptions are another key ingredient in the programmed withdrawal formula. Initially a 0 percent future return was built into the formula, but this was deemed implausible and it produced very low pension payouts. In 1987 the regulator changed this to a positive real interest rate to improve payouts — 80 percent based on the previous year’s internal rate of return on new annuities and 20 percent based on the fund administrator’s average real return over the last 10 years. Pension fund returns were extremely high during the 1980s and early 1990s, while interest rates on annuities (and other investments) have been falling recently. This produces an assumed interest rate for programmed withdrawals that is about 0.5 to 1.0 percentage points higher than the current annuity rate and even higher than the current long-term interest rate. [See Table VI.] This backward-looking method of imputing returns may overestimate expected future returns, when interest rates are falling. Such an overestimate would increase the programmed withdrawal pension in the early years, but the larger withdrawal as well as the smaller investment return that is actually earned would reduce the retiree’s pension and increase the government’s liability in later years.
These programmed withdrawal problems could be avoided by using more conservative assumptions in the formula and by requiring that pensioners also purchase a deferred annuity that begins much later, say at age 80, that would cover the minimum pension.
“Workers should not be allowed to retire too early.”
Early Retirement. Allowing workers to retire early also builds a contingent liability that could have been avoided if they had retired at the normal age. For example, if a worker who started withdrawing at age 60 instead kept his money in the account until age 65, the resulting larger accumulation and shorter future life span would finance a pension that was 50 percent greater. His income in old age would then be greater and the probability that he would some day require a government subsidy would be commensurably smaller. Viewed from this perspective, the government has recently taken steps to tighten access to retirement savings through early retirement — requiring 150 percent of the guaranteed pension and 70 percent of own wage before a worker gets this privilege. However, these conditions may not be sufficient. Possibly 200 percent of the minimum pension guarantee should be required, as the guarantee could easily double over the remaining lifetime of an early retiree, if it continues to be linked to wage growth.
Wage-Linked MPG. In Chile the minimum pension guarantee has been rising on par with wages and faster than prices, while annuities are price-indexed and programmed withdrawal pensions fall in real value as the pensioner ages. Eventually, the rising real pension floor is bound to collide with a constant or falling private pension, which means that the government will then be responsible for paying the difference. The challenge is to make policy regarding the safety net consistent with policies regarding pension payouts. This could be accomplished by partially price-indexing the guaranteed pension amount (rather than linking it to wages) to slow down its growth or by requiring that annuities and programmed withdrawals use an escalating formula (start lower and rise through time) so they are less likely to conflict with a rising pension guarantee.
“The design of an individual account system is crucial to its success.”
The costs of the minimum pension guarantee do not appear when a retiree is “young” since initially his pension exceeds it. I have projected that many pensioners will begin to reach the pension floor in their late 70s or early 80s, as the guaranteed amount rises and programmed withdrawal pensions fall.27 Similarly, in a new system, aggregate costs of the pension guarantee will appear negligible, because retiring cohorts are “young” and don’t yet qualify to receive the public benefit. But as the system matures and some retired cohorts become “very old,” total costs will escalate. This is about to happen in Chile. The rapid increase in number of very old cohorts that will take place over the next decade will bring about a sharp and possibly unexpected acceleration in the proportion receiving the public benefit. This underscores the importance of simulating the long-term flows from private pensions and the public safety net under different scenarios and designs to enable informed choices about payout policies and trade-offs. Such simulations have not been done in the past in Chile, but they are likely to become increasingly important in the future.