Money's Worth Ratios Research Articles

Annuity puzzle: Evidence from a Swiss pension fund

AbstractWe analyze individual annuitization decisions at retirement in an environment with mandatory participation in a funded pension pillar and low average annuity price. Using administrative data from a large Swiss insurance company over the period 2011–2015, we document that, even in this favorable environment, only 42.7% of the retirees fully annuitize, against 45% taking full lump sum. We show that individual annuitization decisions strongly respond to financial incentives, measured by the Money Worth Ratio, and to the tax rates on annuity and lump‐sum payments. Lump‐sum payments are more common among French‐ and Italian‐speaking individuals. Using Survey of Health, Ageing and Retirement in Europe data, we show that French‐ and Italian‐speaking Swiss are more likely to leave inheritance—thus suggesting that preferences for bequests may affect annuitization decisions. Finally, we provide evidence of asymmetric information, using the unused observable test, to show that individuals living in high mortality municipalities are less likely to annuitize and more likely to cash out their pension wealth.

The Money's Worth Ratio Evaluation of Variable Annuities with Guaranteed Minimum Accumulation Benefits

The Money's Worth Ratio Evaluation of Variable Annuities with Guaranteed Minimum Accumulation Benefits

Refundable income annuities: Feasibility of money-back guarantees

Refundable income annuities (IA), such as cash-refund and instalment-refund, differ in material ways from the life-only version beloved by economists. In addition to lifetime income they guarantee the annuitant or beneficiary will receive their money back albeit slowly over time. Although we document that refundable IAs now represent the majority of sales in the U.S., they are mostly ignored by insurance and pension economists. Indeed, their pricing, duration, and money's-worth-ratio is complicated by recursivity which will be explained, and we offer a path forward to make refundable IAs tractable.A key result concerns the market price of cash-refund IAs, when the actuarial present value is grossed-up by an insurance loading. We prove that price is counterintuitively no longer a declining function of age and older buyers might pay more than younger ones. Moreover, there exists a threshold valuation rate below which no price is viable. This may also explain why inflation-adjusted IAs have all but disappeared.

Refundable Income Annuities: Feasibility of Money-Back Guarantees

Refundable income annuities (IA), such as cash-refund and instalment-refund, differ in material ways from the life-only version beloved by economists. In addition to lifetime income they guarantee the annuitant or beneficiary will receive their money back albeit slowly over time. We document that refundable IAs now represent the majority of sales in the U.S., yet they are mostly ignored by insurance and pension economists. And, although their pricing, duration, and money's-worth-ratio is complicated by recursivity which will be explained, we offer a path forward to make refundable IAs tractable. A key result concerns the market price of cash-refund IAs, when the actuarial present value is grossed-up by an insurance loading. We prove that price is counterintuitively no longer a declining function of age and older buyers might pay more than younger ones. Moreover, there exists a threshold valuation rate below which no price is viable. This may also explain why inflation-adjusted IAs have all but disappeared.

The new CPF Life plans as portfolios

We examined the new CPF Life plans - the standard (default) and basic plans - as portfolios of a bond and an obligation to purchase an annuity. This perspective, in contrast to the view that these plans are just annuities, shows that the mandatory scheme does not have universal coverage even for those who are mandated into the scheme, and there are subtle cross subsidies among groups. The basic plan offers real choice for CPF members to substantially reduce further annuitisation by reducing the annuity component of the portfolio and exiting the plan because of the long vesting age. We estimated the money's worth ratio (MWR) of the plans and found that they were not sustainable at the current payouts (1.14 < MWR < 1.93) consistent with previous estimation of earlier plans replaced by the current ones. We predict the payouts will trend downwards after 2023 (the years the first cohort's annuity plans are executed) because the generous MWR are not sustainable. This paper contributes to policy debate about the coverage of the mandatory scheme and the wealth transfer between the insurer and annuitants. Policy questions about wealth transfer among annuitants, and the welfare effect of introducing the scheme, require further research.

The new CPF Life plans as portfolios

We examined the new CPF Life plans - the standard (default) and basic plans - as portfolios of a bond and an obligation to purchase an annuity. This perspective, in contrast to the view that these plans are just annuities, shows that the mandatory scheme does not have universal coverage even for those who are mandated into the scheme, and there are subtle cross subsidies among groups. The basic plan offers real choice for CPF members to substantially reduce further annuitisation by reducing the annuity component of the portfolio and exiting the plan because of the long vesting age. We estimated the money's worth ratio (MWR) of the plans and found that they were not sustainable at the current payouts (1.14 < MWR < 1.93) consistent with previous estimation of earlier plans replaced by the current ones. We predict the payouts will trend downwards after 2023 (the years the first cohort's annuity plans are executed) because the generous MWR are not sustainable. This paper contributes to policy debate about the coverage of the mandatory scheme and the wealth transfer between the insurer and annuitants. Policy questions about wealth transfer among annuitants, and the welfare effect of introducing the scheme, require further research.

Longevity insurance markets and Money's worth ratios in Korea

AbstractThe rare annuitization, thin immediate annuity market, and date limitation have prevented the attempts to analyze the longevity insurance market in Korea. The purpose of this paper is to examine the relative value of Korean annuity rates to theoretical ones and to provide a new evidence on the function of the voluntary annuity market in terms of the money's worth ratio (MWR). Our results show that the immediate annuity market in Korea is reasonably efficient. For example, the money's worth ratio of an immediate annuity of a 10-year guarantee period for a 65-year-old male is estimated to be about 0.8 with the general population mortality rate, while it improves to 0.9 with the annuitant mortality table. Average MWR is similar to that of other countries with thin annuity market, which show that annuitants in Korea pay a comparable cost to that in other countries.

PARTICIPATING PAYOUT LIFE ANNUITIES: LESSONS FROM GERMANY

AbstractThis paper analyzes the framework of German participating payout life annuities (PLAs), which offer guaranteed minimum benefits as well as participation in insurers' surpluses. We show that the process of sharing surpluses between shareholders and policyholders follows transparent and consistent rules. Subsequently, we develop an asset-liability model for a stylized German life insurer that offers PLAs to evaluate benefit variability and insurer stability given stochastic mortality and capital market developments. Our results suggest that guaranteed benefits can be provided with high credibility via PLAs, while, at the same time, annuitants receive attractive money's worth ratios. Moreover, we show that it might be difficult to offer a fixed benefit annuity providing the same lifetime utility as a PLA for the same premium and a comparably low insolvency risk. Overall, PLA schemes may be an efficient way to deal with risk factors that are highly unpredictable and difficult to hedge over the long run, such as systematic longevity and investment risks.

The Annuity Duration Puzzle

We test whether life-contingent annuity prices promptly and fully adjust to changes in interest rates; a standard assumption made implicitly or explicitly in a growing annuity literature. Using a unique database consisting of over 3 million U.S. annuity quotes, we find that prices do not move as one might expect. Rather, prices adjust gradually and over a period of several weeks and often months, in response to certain -- and not necessarily riskless -- interest rate changes. In particular, we find that changes to the 30-year U.S. mortgage rate provide a better fit and indication of where annuity payouts are headed, compared to the 10-year swap rate, for example. In addition, we find that the sensitivity to interest rate changes (a.k.a. annuity duration) is asymmetric. Annuity prices react more rapidly and with greater sensitivity to an increase in the relevant interest rate compared to a decrease. Overall our findings are inconsistent with a financial economic view of a life annuity as a risk-free bond-like instrument, plus mortality credits. We believe that we are the first to examine the dynamic microstructure of annuity prices and that our results have implications for a wide swath of existing literature. This includes portfolio choice at retirement, the optimal timing of annuitization, the money's worth ratio, the inference of mortality expectations from insurance prices as well as the valuation of pension liabilities.

Comparison of the Money's Worth Ratios between Reverse Mortgages and Single Premium Immediate Annuity

Comparison of the Money's Worth Ratios between Reverse Mortgages and Single Premium Immediate Annuity

The Private Value of Public Pensions

Individual retirement savings accounts are replacing or supplementing public basic pensions. However at decumulation, replacing the public pension with an equivalent private sector income stream may be costly. We value the Australian basic pension by calculating the wealth needed to generate an equivalent payment stream using commercial annuities or phased withdrawals, but still accounting for investment and longevity risks. At age 65, a retiree needs an accumulation of about 8.5 years earnings to match the public pension in real value and insurance features. Increasing management fees by 1% raises required wealth by about one year's earnings. Delaying retirement by 5 years lowers required wealth by about one half year's earnings. Phased withdrawals have money's worth ratios close to 0.5 suggesting that private replacement costs are high.

An empirical analysis of the annuity rate in Chile

SUMMARYEmpirical analyses of annuities markets have been limited to a few developed countries and restricted by data limitations. Chile provides excellent conditions for research on annuities due to the depth of its market and the availability of data. The paper utilizes a panel of life insurance company data to examine econometrically the main determinants of the annuity rate, defined as the internal rate of return on annuities. The results indicate that the annuity rate is determined by the risk-free interest rate, the share of privately issued higher yield securities in the portfolio of providers, as a proxy for the spread over the risk-free rate, the leverage of providers, the level of broker's commissions, the market share of individual providers, the level of the premium, and the degree of market competition. The results also show that efforts to improve market transparency produced structural shifts in the parameters of the annuity rate equation. The results are consistent with separate research on money's worth ratios, and indicate the need to develop appropriate financial instruments, allowing providers to hedge their risks while extracting higher returns, and also to ensure competition and transparency in annuities markets, in order to ensure good outcomes for annuitants.

An analysis of money's worth ratios in Chile

AbstractEmpirical analyses of annuities markets have been limited to a few developed countries and restricted by data limitations. Chile provides excellent conditions for research on annuities due to the depth of its market and the availability of data. The paper utilizes an extensive dataset on individual annuities to examine econometrically a measure of market performance – money's worth ratios (MWRs), or the ratio of the expected present value of annuity payments to the premium. The results show that annuitants in Chile have generally got a good deal for their premiums, as indicated by MWRs higher than one and also higher than those estimated for other countries. The difference between Chile and other countries is striking considering that annuities in Chile are indexed to prices. The wide range of indexed instruments in Chile, allowing providers to hedge their risks while extracting higher returns, helps explain the difference. The high degree of market competition has also contributed to this outcome. Efforts to improve market transparency through a new electronic quotation system have decreased the dispersion of MWRs. Finally, MWRs tend to decrease for contracts with longer durations, reflecting pricing for higher longevity and reinvestment risks. These results are consistent with separate research on the annuity rate, and indicate the need to ensure competition and market transparency, as well as to develop appropriate financial instruments for providers in order to ensure good outcomes for annuitants.

The payout stage in Chile: who annuitizes and why?

In 1981 Chile adopted its new multi-pillar system, which featured privately managed individual accounts. Starting in 1983 payouts from the accounts were permitted and detailed rules about payouts were put in place. The Chilean scheme therefore gives us an opportunity to examine how pensioners and pension providers react when individual accounts replace DB systems, and how detailed regulations shape these reactions.Retirees in Chile have a choice between early versus normal retirement (before or after age 65M/60W) and between annuitization versus programmed withdrawals; lump sum withdrawals are largely ruled out. Almost two-thirds of all retirees have annuitized – a very high proportion compared with other countries. This paper argues that this high rate of annuitization is the result of guarantees and regulations that constrain payout choices, insure retirees through the minimum pension guarantee, eliminate other DB components, and give a competitive advantage to insurance companies selling annuities. The minimum pension financed by the government provides insurance to workers with small accumulations, who retire at the normal age with programmed withdrawals, while those with large accumulations retire early and must purchase annuities to acquire longevity and investment insurance. Insurance companies further induce annuitization by marketing aggressively, facilitating early retirement for those who annuitize and offering a high money's worth ratio for price-indexed annuities. We find evidence of adverse selection based on asymmetric information about short-run health status, but this does not seem to deter the high rate of annuitization.

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.