Private Pension Annuities in Chile

Studies | Social Security

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


  1. This paper is based on data and analysis provided in Estelle James, Guillermo Martinez and Augusto Iglesias, "Payout Choices by Retirees in Chile: What Are They and Why?" paper presented at the annual meeting of the American Economic Association, January 2004. The author wishes to thank the Michigan Retirement Research Consortium and the Social Security Administration for their support on this project, and the many representatives from insurance companies, the pension fund administrators (AFPs) and their regulators (SVS and SAFP) in Chile who shared their information and insights. Jorge Lillo performed the analyses of mortality rates among annuitants, Xue Song performed the money's worth calculations, and Juan Pablo Contreras assembled much of the aggregate data.
  2. We use three types of data sources in this analysis: First, aggregate time series data on annuities and programmed withdrawals, 1983-2002, were obtained from the insurance regulator (the Superintendencia de Valores y Seguros or SVS) and the regulator (the Superintendencia de AFP or "SAFP") of pension fund administrators (the Administradoras de Fondos de Pensiones or "AFPs"). Second, SVS provided individual-level data on all annuitants giving gender, size of accumulations and pensions and dates of birth, retirement and death. In this paper, these data are used to report descriptive statistics on annuitants and to compare expected versus actual mortality rates across groups. Unfortunately, reliable individual-level data on pensioners who chose programmed withdrawal (PW) pensions were not available. Third, the author held extensive discussions with insurance companies, AFPs and regulators in Santiago, and obtained annuity quotes from several companies for 1999 and 2003, from which money's worth ratios were calculated. For more details on data, see James, Martinez and Iglesias, "Payout Choices by Retirees in Chile: What Are They and Why?" and James, Martinez and Iglesias, "The Payout Stage in Chile: Who Annuitizes and Why?" working paper, 2004.
  3. The start of the annuity payout can be postponed two to three years through a program called "temporal withdrawals," in which workers purchase a deferred annuity upon retirement, but initially take programmed withdrawals; however, few retirees have taken this option.
  4. In August 2004 the Chilean government adopted some changes in its payout scheme that will be gradually phased in by 2010. Forms of payout have become more flexible. For example, variable annuities and annuities denominated in foreign currencies will be permitted as soon as implementing regulations are developed, a pension that combines an annuity plus programmed withdrawal will be allowed in the future, and banks will be authorized to sell annuities. At the same time, the requirement for early retirement is gradually being raised (to 70 percent of one's own wage and 150 percent of the minimum pension guarantee), the definition of average wage used in this requirement has been tightened, a limit has been set on sales commissions to brokers selling annuities and an electronic quotation system is now required for annuity sales. The greater flexibility and increased information should make annuities more attractive but the tightening of early retirement preconditions might reduce demand and restrictions on commissions might reduce marketing costs and impact. This paper analyzes the system that has been in effect for the past 22 years.
  5. To receive government funds to bring their pension up to the minimum level, workers must attest that they have no other income sources that bring them above that level. This means test is enforced by the fund administrators or insurance companies paying the pension, which are required to secure documents from the tax authority and the old pension authority confirming the absence of other income.
  6. One advantage of a minimum pension guarantee is that it is relatively easy to implement administratively - simply by checking the individual's own annuity or programmed withdrawal pension. The transaction costs are much lower than for means-testing based on more general income and assets. However, this also means that some individuals with small pensions but large nonpension wealth or income get a public subsidy - which many would regard as a poor use of public funds. Chile attempts to avoid this possibility by making eligibility for the top-up contingent on the absence of other sources of income. But this reintroduces a means test and the transaction costs it implies. Chile passes these enforcement costs on to the fund administrators and insurance companies. This makes retirees with low pensions expensive to such companies, and undesirable if these costs can't be recouped. While required to enforce means-testing, these companies have little incentive to do so carefully. We are unable to assess how effectively the broader income test is implemented.
  7. For details, see Appendix Table I.
  8. If it had been indexed only for price inflation, the minimum pension would have fallen to 17 percent of the average wage and if not indexed at all, to barely 1 percent.
  9. The programmed withdrawal (PW) formula for an individual pension is
    Premium = 12*p*prem + EPV(UF15), where:
    Premium = retiree's total accumulation
    p = monthly pension, whose value is being ascertained by this formula
    prem = EPV of pension that equals 1 UF monthly = (Nx/Dx- 11/24)
    Nx and Dx are standard actuarial factors that depend on mortality and interest rates
    EPV(UF15) = expected present value of UF15, which is the necessary capital for the funeral benefit of Chilean UF15 that must be included in all policies
    In the common case of a joint withdrawal, in determining p and prem enough capital must be set aside to cover 60 percent of p for the surviving spouse, as well as p for the pensioner, so prem = (Nx/Dx- 11/24) + .6(Ny/Dy- Nxy/Dxy).
    This is exactly the same as the formula for an annuity and will produce the same payout for a given premium if the same mortality and interest rates are used.
  10. For full details, see Appendix Tables II and III.
  11. The 13 percent figure is based on a 10 percent net contribution plus 3 percent for administrative expenses and disability and survivors insurance. The increase in liquidity of retirement savings and in monthly income flows may lead some workers to withdraw from the labor market. This would hold for workers who have been forced to save more than they would have chosen for their retirement, and who prefer to spend some of that saving on leisure instead of material consumption. But the elimination of the 13 percent payroll tax may have a positive effect on continued labor supply. The liquid wealth and the substitution effects therefore work in opposite directions in influencing the labor supply of older workers. In either case, workers can no longer increase the present value of their pension by withdrawing from the labor force, as they could in the old defined benefit system. This reduces the incentive that existed in the old system to stop working early. Preliminary evidence indicates that the labor force participation rate of older workers has been rising since the mid-1980s, very likely as a result of the pension reform.
  12. Appendix Table IV shows details.
  13. Also see Estelle James, Alejandra Cox Edwards and Rebeca Wong, "The Gender Impact of Pension Reform: A Cross-Country Analysis," World Bank, Research Working Paper No. 3074, 2003.
  14. Simulations show that the expected widow's benefit exceeds both the own pension of the average working woman and the minimum pension guarantee; see Estelle James, Alejandra Cox Edwards and Rebecca Wong, "The Gender Impact of Pension Reform," Journal of Pension Economics and Finance, 2003. Chile also has a means-tested social assistance program for the destitute elderly. Widows who receive the joint annuity are less likely to qualify for social assistance. The requirement that most wives purchase individual pensions also saves money for the government, since it yields a higher monthly payout for a group that tends to contain many low earners and greater life expectancy. This means that fewer women annuitants will qualify for the MPG than would be the case if they purchased joint annuities.
  15. Under the old system, workers received a defined benefit, which is like an annuity. Most workers over the age of 55 remained in the old system. Therefore, the new system did not have many old age retirees during the 1980s.
  16. Prior to 1987 D&S benefits were provided directly by the pension fund administrators (AFPs). The AFP typically insured these benefits through an affiliated insurance company, an arrangement known as "cubierta por el seguro." Often these companies were in the same financial conglomerate as the AFP, so the purchase was not made at arm's length in a competitive market. These benefits were like forced group annuities, in the sense that they provided longevity and investment insurance to beneficiaries, but the terms and vendor were chosen by the AFP rather than by the individuals who ultimately paid the insurance premiums. In 1987 this system was changed to the system described in the text.
  17. Also see Appendix Tables II and III.
  18. In Singapore these withdrawals have led to a heavy investment in housing by workers and to very low cash balances upon retirement. It remains to be seen which choices will be made in Australia, where the system is relatively new, so few workers have retired under it. The combination of unconstrained choice and insurance provided by the means- and asset-tested old age pension on relatively generous terms makes it unlikely that most people will annuitize.
  19. If the worker has enough money in his account to purchase a pension that is at least 70 percent of his average wage, he is allowed to draw the rest in a lump sum. Few workers achieve this size accumulation. However, insurance companies can help them do so - for example, by lending them money to put into the account to achieve the 70 percent replacement rate.
  20. Also as expected, early retirees who do not annuitize have much larger accumulations and pensions than those who do annuitize. This may occur because wealthier individuals are better able to acquire their own information about early retirement and to self-insure against longevity and investment risk. They may also be more anxious to manage their own investment strategy, to take greater risks in order to get a greater return, and to leave a bequest to their heirs - all of which are possible with programmed withdrawals but not with annuities.

  21. Concretely, the money's worth ratio for a single life annuity is:
  22. Actually, we used the term structure of interest rates, which gives a different rate for income flows in different periods. For 2003 the risk-free term structure was based on 0 coupon bonds while for 1999 it is based on central bank bonds of differing maturities, since 0 coupon bonds did not exist at that time. The risky rate was defined as risk-free +1.4 percent, which is approximately what insurance companies in other countries, as well as Chile, have earned, on average per year, over the past decade. See Estelle James and Xue Song, "Annuity Markets Around the World: Money's Worth and Risk Intermediation," CeRP Working Paper 160/0, 2001.
  23. In the mandatory part of the U.K. system annuities must be indexed up to a ceiling of 5 percent inflation. Other countries with new multipillar systems are considering requiring indexed annuities, but this may be difficult to implement given the absence of indexed financial instruments. See Mamta Murthi, J. Michael Orszag and Peter Orszag, "The Value for Money of Annuities in the U.K.: Theory, Experience and Policy," Birkbeck Working Paper, 1999; also see Amy Finkelstein and James Poterba, "The Market for Individual Annuity Products in the United Kingdom," National Bureau of Economic Research, NBER Working Paper No. 7168, 1999, and Finkelstein and Poterba, "Adverse Selection in Insurance Markets: Policyholder Evidence from the U.K. Annuity Market," National Bureau of Economic Research, NBER Working Paper No. 8045, 2000.
  24. For further discussion of the MWR in other countries, see Estelle James and Xue Song, "Annuities Markets Around the World: Money's Worth and Risk Intermediation," and Estelle James, Xue Song and Dimitri Vittas, "Annuities Markets in Comparative Perspective: Do Consumers Get Their Money's Worth?" World Bank, Conference on New Ideas for Old Age Security, 1999.
  25. For a detailed discussion of the spread, see Estelle James, Xue Song and Dimitri Vittas, "Annuity Markets Around the World: Money's Worth to Annuitants and How Do Insurance Companies Cover It?" Working Paper, 2003.
  26. See Estelle James, Guillermo Martinez and Augusto Iglesias, "The Payout Stage in Chile: Who Annuitizes and Why?" for more details on adverse selection analysis.
  27. For details of these simulations, see James, Martinez and Iglesias, "Payout Choices by Retirees in Chile: What Are They and Why?"

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