The Overtaxation of Life Annuities: the French Case

Abstract

Protection against the prospect of living too long is an important factor in old-age savings decisions. Without the possibility of efficiently converting savings into life annuities, a person is at risk of having lower-than-expected living standards if she lives a long time, or leaving a larger inheritance than she wishes if she dies early. This could adversely impact the pool of savings in a country, and create negative externalities as more people rely on relatives or the social system for support in old age.Generally, tax systems consider the purchase of life annuities as a personal investment. If savings are built up from income that has not been subjected to income tax, life annuities are typically fully taxed as income when they are received. That is how pension funds usually work. Primary income taxation is actually postponed, such that taxation is more or less neutral as regards saving decisions.But even if savings are built up from income on which tax has already been paid, life annuities are not usually tax-free: tax will apply to the component of annuities that can be considered as investment income.In France, the rule is to tax as income a portion of life annuities (ranging from 30% to 70%, depending on the age at which they are at first received), at rates of up to 50% including “social security contributions”.For the “average” person whose life matches the official mortality tables, this taxation dramatically erodes the internal rate of return on life annuities considered as an investment. For instance, an annual gross (pre-tax) return of 3%, which can be considered the norm for low-risk investment (net of various management fees), will be reduced to a net (after-tax) 0.5%-1.0%, depending on the age at the annuity start date. This is equivalent to a huge tax rate on nominal return: 66% to 83%. Since, assuming a long-term inflation rate of 2%, a nominal 3% return corresponds to a real return of around 1%, the effective tax rate on the real return is well above 100%, which means that some of the capital itself is confiscated.These findings are slightly mitigated for higher return rates, which entail more risk-taking, but old people are generally considered highly risk-averse, which means they tend to show little interest in annuities which vary according to investment performance, or for escalating or index-linked annuities. Men, whose life expectancy is lower, are hit harder than women. Under any realistic assumptions, the effective rate of taxation remains very high and well above the average tax on ordinary savings.The paper suggests ways of addressing the overtaxation of life annuities, by adjusting the tax rates and the taxed portion to more realistic levels.