Demand For Annuities Research Articles

Annuities and Individual Welfare

Advancing annuity demand theory, we present sufficient conditions for the optimality of full annuitization under market completeness which are substantially less restrictive than those used by Menahem E. Yaari (1965). We examine demand with market incompleteness, finding that positive annuitization remains optimal widely, but complete annuitization does not. How uninsured medical expenses affect demand for illiquid annuities depends critically on the timing of the risk. A new set of calculations with optimal consumption trajectories very different from available annuity income streams still shows a preference for considerable annuitization, suggesting that limited annuity purchases are plausibly due to psychological or behavioral biases.

Does the balance of power within a family matter? The case of the Retirement Equity Act

This paper studies within-family decision making regarding investment in income protection for surviving spouses using a simple and tractable Nash-bargaining model. A change in US pension law (the Retirement Equity Act of 1984) is used as an instrument to derive predictions from the bargaining model about the household demand for survivor annuities and life insurance and to contrast these with the predictions of the classical single-utility-function model of the household. In the empirical part of the paper, the predictions of the classical model are rejected in favor of the predictions of the Nash-bargaining model.

Household Demand for Variable Annuities

Between 1990 and 2000, total sales of variable annuities in the U.S. grew from just over $5 billion to nearly $140 billion. These products now account for approximately half of all private market annuity sales. Variable annuities resemble mutual funds, but they qualify for special tax treatment as insurance products because they provide an option to convert to a life annuity. This paper describes the tax treatment of variable annuities and presents summary information on the ownership patterns for variable annuities. It also explores the relative importance of several distinct motives for household purchase of variable annuities. We use household data from the 1998 and 2001 waves of the Survey of Consumer Finances to examine ownership patterns and to test for the importance of tax and insurance considerations in variable annuity demand. We find that variable annuity ownership is highly concentrated among high income and high net wealth sub-groups of the population, although the concentration is lower than for several other categories of financial assets. We find mixed support for the role of tax considerations in generating variable annuity demand, and we outline a set of research issues that focus on household annuity purchases.

The Economics of Annuities

The challenges of an ageing global population are among the most pressing on the public policy agenda. However, in looking at issues around retirement income, the emphasis has largely been on the accumulation phase: saving for retirement. So far, rather less attention has been paid to the decumulation phase: turning the pot of savings into an income stream. However, as more and more people approach retirement, this becomes the key issue for them. There are potentially significant risks for the consumer in converting savings into income, the most pressing being to ensure they do not outlive their savings. Insurance companies therefore have a key role to play in this, in providing annuities. An annuity is a product which is designed to give the purchaser, the annuitant, an income for life, however long or short that is. It is the only financial contract that provides an income for life. Thus, for a single payment, it insures the purchaser against outliving his assets. However, the opportunities presented by this market are not without their risks. This article will begin by considering the demand for annuities, in part by looking at the U.K. experience. Last year, the Association of British Insurers carried out research into the characteristics of annuitants in the U.K. So, drawing on this, I will explore some of the drivers of demand now and in the future; what informs the decision to buy an annuity; the characteristics of annuitants in the U.K.; and what the risks are for the purchaser. Then the article will examine issues around the supply of annuities, including who provides annuities; what types of annuities there are; how they are funded; what drives profitability; and what the risks to the annuity provider are. This leads into issues of price and, in particular, whether annuities are seen as providing value for money and, indeed, how that might be measured.

Annuities and Individual Welfare

Advancing annuity demand theory, we present sufficient conditions for the optimality of full annuitization under market completeness that are substantially less restrictive than those used by Yaari (1965). We examine demand with market incompleteness, finding that positive annuitization remains optimal widely, but complete annuitization does not. How uninsured medical expenses affect demand for illiquid annuities depends critically on the timing of the risk. A new set of calculations with optimal consumption trajectories very different from available annuity income streams still shows a preference for considerable annuitization, suggesting that limited annuity purchases are plausibly due to psychological or behavioral biases.

Annuities Markets Around the World: Money's Worth and Risk Intermediation

Annuities markets around the world are small. However, they have been growing in recent years and are likely to grow further as a result of reforms in public social security systems and private pension plans, that partially replace defined benefit plans with funded defined contribution plans. When people retire they may choose, and are sometimes required, to annuitize these defined contribution savings. Therefore, it is important to learn whether or not annuities markets exist, how they operate and what kinds of market failure can be anticipated. Several papers have already analyzed US annuities markets. This paper extends that analysis by examining annuities markets in other countries. We present evidence from Canada, the UK, Switzerland, Australia, Israel, Chile and Singapore - a variety of high and middle-income countries - and replicate the results from the US. This paper focuses on analyses of the expected present discounted value (EPDV) of cash flows from the annuity, and the money's worth ratio (MWR), which is the EPDV divided by the initial premium cost. We find that, when discounting at the risk-free rate, MWR's for annuitants are surprisingly high - greater than 95% in most countries and sometimes greater than 100%. MWR's for the average population member are lower but still exceed 90% in most cases. We show that differential interest rate structures largely explain differential monthly payouts across countries, while differential mortality rates, especially projected improvement factors, help explain differences in measured MWR's, given these monthly payouts and interest rates. The high MWR's raise the question: How do insurance companies cover their costs despite these high MWR's? We hypothesize that for each annuity sale, insurance companies get a large sum of money up-front that they invest in a portfolio of corporate bonds, mortgages, and some equities, earning a rate of return that exceeds the risk-free rate by 1.3% or more per year. They turn this risky portfolio into a safer annuity by a variety of risk-intermediation, term-intermediation techniques. This allows them to sell a product that is nearly risk-free, while earning a that covers their costs. We present data on cost and investment returns that are consistent with this hypothesis. The limited opportunity to earn this spread may help explain why price indexed annuities in the UK charge higher loads to cover their costs and risks. For consumers who would prefer to accept this investment risk and capture this spread themselves, the appropriate discount rate is higher and the MWR is lower, helping to explain the low demand for annuities in voluntary markets.

Mortality Swaps and Tax Arbitrage in the Canadian Insurance and Annuity Markets

The authors analyze a tax arbitrage opportunity that results from engaging in two seemingly counterintuitive transactions in the Canadian insurance market. Specifically, if an individual acquires a fixed immediate life annuity and then uses the periodic annuity income to fund a term-to-life insurance policy, these two transactions, which the authors refer to as a “mortality swap,” will generate a payoff pattern that is risk-free. In other words, a mortality swap replicates a risk-free security, albeit one with a stochastic liquidation date. The authors show theoretically that the rate of return on a mortality swap is equal to the risk-free rate on a before-tax basis, but exceeds it on an after-tax basis. This is confirmed by the results of the empirical test, which uses observed annuity and insurance quotes that already reflected adverse-selection and transaction costs. The authors also observe that the older an individual is and/or the higher his/her marginal tax rate is, the more he/she stands to gain from this tax arbitrage. This advantageous investment opportunity exists because of the arguably lenient method that Canadian authorities use to tax annuity income. The authors provide two major reasons that this method leads to an arbitrage opportunity. The authors then compare this method to that under the U.S. tax rules and show that the U.S. method renders tax arbitrage very unlikely. The demand for life insurance and annuities is usually attributed to risk aversion, consumption smoothing, and the desire for household protection. The authors’ findings provide an arbitrage-based reason for their demand. As a natural by-product, the authors’ research contains policy implications for the optimal taxation of annuities and insurance policies. Narat Charupat is assistant professor of finance at the DeGroote School of Business, McMaster University. Moshe Arye Milevsky is associate professor of finance at the Schulich School of Business, York University, and the Director of the Individual Finance and Insurance Decisions (IFID) Centre in Toronto, Canada. Financial support from the Life Underwriters Association of Canada (Charupat), the York University Research Authority, and the SSHRC (Milevsky) is gratefully acknowledged. The authors would like to thank Glenn Daily, Clarence Kwan, and the two anonymous referees for their helpful suggestions, as well as Lowell Aronoff (CANNEX), John Hitchcock (SunLife), Jon Archer (RBC), and Zale Newman (PanFinancial) for providing data on insurance and annuity quotes. Any errors are the authors’ responsibility.

Adverse Selection in the Annuity Market When Payoffs Vary over the Time of Retirement

This study deals with a specific implication of adverse selection for annuity pricing. Varying the time path of the payoffs over the retirement periods affects the annuity demand and welfare of individuals with low and with high life expectancy in different ways. Therefore they can be separated by insurance firms through appropriate contract offers. We show that in this framework a Nash-Cournot equilibrium may not exist; if one exists, it will be a separating equilibrium. On the other hand, even if a separating equilibrium does not exist, a Wilson pooling equilibrium exists.

Adverse Selection in the Annuity Market When Payoffs Vary Over the Time of Retirement

This paper investigates the effect of adverse selection and price competition on the private annuity market in a model with two retirement periods. In this framework annuity companies can offer contracts with different payoffs over the periods of retirement. Varying the time structure of the payoffs affects annuity demand and welfare of individuals with low and high life expectancy in different ways. By this, annuity purchasers can be separated according to their survival probabilities. Our main finding is that a Nash-Cournot equilibrium may not exist; if one exists, it will be a separating equilibrium. On the other hand, even if a separating equilibrium does not exist, a Wilson pooling equilibrium exists.

Joint Life Annuities and Annuity Demand by Married Couples

ABSTRACT This article summarizes the range of joint-life products that are currently available to married couples, and it explores the potential utility gain that such couples receive from access to actuarially fair markets. It is more difficult to estimate this utility gain for couples than for individuals because a couple's value of annuitization will depend in part on the survivor benefits that are available after one spouse has died but while the other is still alive. Valuing joint and survivor annuities also requires recognition of the potentially important interactions between the members of a married couple, such as joint consumption, interdependent utilities, and correlated mortality rates. This article considers each of these issues. It develops an valuation model for married couples and it estimates their annuity equivalent wealth, the amount of wealth that couples would need in the absence of actuarially fair markets in order to achieve the same utility level that they rece ive when such markets are available. The utility gain from annuitization is smaller for couples than for single individuals. Since most potential buyers are married, this finding may help to explain the limited size of the market for single premium annuities in the United States. INTRODUCTION Annuities play an important role in the standard theory of consumer choice when life length is uncertain. Yaari (1965) showed that an individual with a fixed stock of resources and an uncertain lifetime should purchase an contract to insure against the risk of outliving his resources. More recent work, such as Mitchell, Poterba, Warshawsky, and Brown (1999) (hereafter MPWB), finds substantial gains to annuitization for individual life-cycle consumers. Typical results suggest that a 65-year-old man who does not have access to an actuarially fair market would be willing to forgo roughly one-third of his wealth if by doing so he could purchase an actuarially fair with his remaining wealth. In spite of Yaari's (1965) insight, a number of studies have observed that the market for individual contracts in the United States is very small. Standard explanations for the limited flow of new purchases are adverse selection in the market, individual bequest motives, and the presence of other annuitized resources. Several empirical studies, including Friedman and Warshawsky (1988, 1990) and MPWB (1999), have explored the extent of adverse selection. Numerous other studies surveyed in Laitner (1997) and (more briefly) in Altonji, Hayashi, and Kotlikoff (1997) and Laitner and Juster (1996) have focused on intergenerational altruism as a potential explanation for limited demand. Simple altruistic models do not appear to provide a satisfactory explanation for observed patterns of intergenerational transfers. Auerbach, Kotlikoff, and Well (1992) show that when Social Security benefits, private defined benefit pension plan payments, and Medicare benefits are added together, more than half of the resources of the current elderly in the United States take the form of life-contingent payouts. Thus many households are already annuitized. This may also explain the limited demand for additional private annuities. The functioning of markets has recently attracted attention as part of the global policy debate on individual accounts Social Security systems. A central design issue in such systems concerns the way a retiree would spread accumulated resources over his or her remaining lifetime, or his or her lifetime and that of his or her spouse. Private annuities offer one way of spreading such resources; mandatory government-provided annuities are another. Although the treatment of married couples is an important issue in retirement income security, virtually all of the previous research on annuities has focused on individuals rather than couples as decision-making units. …

Income uncertainty and the demand for annuities

Two well-known results concerning the demand for annuities in an overlapping generations model are: (i) egoistic agents should annuitize all their wealth; and (ii) altruistic agents should segment their savings between riskless bonds (for bequests) and annuities (for own consumption). This paper extends the analysis by considering income uncertainty. It is shown that while the ‘segmentation’ result holds under future generation’s income uncertainty (FGIU), altruistic agents do not segment their savings in the presence of second-period income uncertainty (SPIU); the intuition for this result is that income uncertainty in the second period of life is contingent on being alive, and therefore at the optimum the covariance between one’s offspring’s consumption and life uncertainty is not zero, as in the case of certainty and FGIU. The effects of precautionary savings on the demand for annuities are also analyzed.

Income uncertainty, bequests and annuities

Life uncertainty and income uncertainty are modeled simultaneously in order to analyze the influence of perfecting income insurance in the size of bequests and the demand for annuities. The main result shows that government intervention aimed at providing intergenerational risk sharing acts as a bequest substitute, and if annuities are available, reduces the demand for annuities.

How Strong Are Bequest Motives? Evidence Based on Estimates of the Demand for Life Insurance and Annuities

This paper presents new empirical evidence in support of the view that a significant fraction of total saving is motivated by the desire to leave bequests. Specifically, I find that social security annuity benefits significantly raise life insurance holdings and depress private annuity holdings among elderly individuals. These patterns indicate that the typical household would choose to maintain a positive fraction of its resources in bequeathable forms, even if insurance markets were perfect. Evidence on the relationship between insurance purchases and total resources reinforces this conclusion.

On the determinants of individual demand for pension annuities

This paper derives individual pension demand under uncertainty. The derived pension demand function is then estimated by positing a general functional form which includes linear and logarithmic forms as special cases. Our empirical study finds no relationship between absolute demand for pensions and wealth but lends support to the hypothesis that there is a significant positive relationship between pension demand and the income tax rate.

The Effects of Survival Probabilities, Transactions Cost and the Attitude Towards Risk on the Demand for Annuities

Uncertain lifetimes induce two different types of insurance markets: (a) annuity, and (b) life insurance. The annuity market differs crucially from the life insurance market in two important respects: (1) The demand for (term) life insurance will be generated by a bequest motive; (2) the demand for life insurance will be positive if the decision-maker (dm) chooses to borrow against future income streams. On the other hand, intertemporal decision making with uncertain lifetimes alone is a strong enough motivation for the existence of an annuity market. In this paper, we shall investigate how survival probabilities (and longevity), transactions cost and attitude towards risk affect the demand for annuities. Some of the results are counter-intuitive. These results need not carry over to the life insurance market because of the fundamental differences between an annuity and the life insurance. The paper is organized as follows: section II lays out the basic two period framework in which the analysis is carried out in section III. Section IV concludes with a discussion of our results and directions for future research.