Payout policies and choices in Chile (and some comparisons)

1. Payout policies and choices in Chile (and some comparisons) by Estelle James Prepared for World Bank HD week, November 2006

2. The payout stage—often neglected in pension reforms • In individual account (DC) systems individuals accumulate funds, to finance their retirement • What policy choices must be made about payouts? • What forms of payouts do retirees choose? • How do private producers respond? • What problems are likely to arise? • We look at Chile, which has had individual accounts for 24 years, therefore many retirees • Compare with UK, Australia, Fiji and other countries with newer systems

3. Rules of the game—payouts constrained in Chile • Workers are required to save for their old age because of myopia—so how do policy-makers deal with myopia at retirement? How do they prevent money from being used up quickly? • Retirees must purchase annuity from insurance company or gradual withdrawal (GW) from AFPs • Annuity gives fixed payouts guaranteed for life • GW payouts follow formula set by regulator, vary according to investment returns, until money runs out • Lump sum not permitted unless pension >70% worker’s average wage

4. Other important rules and constraints • Pensions must be price-indexed—(maintain real value) • Gender-specific mortality tables used (so women get lower monthly payouts for more years) • But pension must be joint for married men—protects widows at no cost to public treasury • Widows keep own pension + joint pension • Normal retirement age 65M, 60W but can start pension early if preconditions are met (50% replacement rate, going up to 70%)

5. 3 key choices in Chile • Workers in Chile must decide 1) when to start pension, 2) when to stop work and 3) whether or not to annuitize • 60% of all retirees have met pre-conditions and started pension early • can continue working, exempt from pension payroll tax—and many do so (lfpr of older men has risen) • 2/3 of all pensioners have annuitized—very high % • Most annuitants are early retirees. 85% of early retirees but only 35% of normal retirees have annuitized • Why the high annuitization rate in Chile but not in other countries? Who annuitizes?

8. Why do most pensioners annuitize in Chile? Policies constrain options, shape incentives • No public or private DB, except for MPG • if retirees want guaranteed life income, must annuitize • Limited options—annuity or gradual withdrawal • Avoids temptation to take savings in lump sum • Competitive advantage to insurance companies • they are allowed to pay sales commissions to independent brokers, while AFP’s can’t • Guarantees • Government guarantees annuity (MPG +75% > MPG)

9. And private insurance companies market aggressively • Enter industry and compete for captive clients • Industry grew rapidly--Reserves grew from < $.5 billion 1985 to>$14 billion 2002 (20% GDP) • Salesmen help retirees meet pre-conditions for early retirement and sell them annuities • Tell workers of eligibility, loans, handle paperwork • Sell annuities at same time—ER is the carrot • Therefore workers who retire early are most likely to annuitize—85% of early retirees, 35% normal retirees • Companies pay high money’s worth ratio (MWR) to attract customers

10. MWR=100% on price-indexed annuities • Money’s worth ratio (MWR) is expected present value of lifetime payments/premium • If 100%, annuitant gets back premium + interest + longevity insurance • Insurance companies pay risk-free rate, earn higher return on diversified portfolio—covers their costs • In UK MWR=98% for nominal annuities, 89% for indexed annuities. Why the higher MWR in Chile? • price indexation required so no adverse selection • many indexed investment instruments available so companies can invest in indexed long term private bonds and mortgages, while in UK only government bonds are indexed—more inflation risk, lower return

11. Contrast payout policies in Chile with UK, Australia, Fiji • UK—Part from payroll tax rebates constrained • Joint annuities, unisex tables, price-indexation required • Payroll tax rebates new--few have retired on them yet • Fewer restrictions on voluntary contributions • Annuities or gradual withdrawals + 25% as lump sum • Payouts don’t have to be joint or price-indexed • Little annuitization over many years • Australia—few restrictions, practically no annuitization • Fiji—annuities, GW and lump sums allowed • Annuities paid by public institution on very favorable terms (MWR 200%)—private companies can’t compete • 25-30% retirees have annuitized

12. Lower annuitization in UK, Australia and Fiji because: • UK • Government provides flat benefit to most retirees + means-tested benefit to many—so less need for annuity • Voluntary contribution—options less limited, part can be taken as lump sum • Government does not guarantee annuity • Australia • Government pays almost universal basic benefit • Lump sums permitted, no guarantees or subsidies • Fiji • Lump sum payouts permitted • Annuities provided by public institutions at high subsidized rates but no marketing by private companies

13. But all Chileans do not annuitize • Chile offers minimum pension guarantee after 20 years’ contributions (25-27% average wage). • If original pension < 100% MPG, not allowed to annuitize (annuity would be too small) • If original pension close to MPG, workers choose gradual withdrawal and keep bequest rights. They get longevity insurance from MPG • Retirees with very large accumulations (>5MPG) self-insure through GW, keep bequest & inv rights • For workers in-between, MPG floor is far below annuity they could afford—little protection. They choose annuity to get longevity insurance. • Average annuity nearly double average GW. Probits.

14. Do unhealthy avoid annuities? Limited evidence of adverse selection • Adverse selection means: workers in poor health who expect to die young don’t annuitize, so insurance companies are left with bad risks (high lifetimes), offer low payouts that further discourage av. annuitization • Avoid if info to differentiate rates by health status • Data on mortality for annuitants show: • Actual deaths much less than expected during first few years of exposure—adverse selection in short run • Annuitization lower if health emergency led to ER • Given 67% annuitization rate, adverse selection not big • Those in poor health buy annuities with 10-20 year guaranteed payment periods: product differentiation • Adverse selection much greater in UK • Smaller % annuitize and greater longevity difference

15. Summary of policy issues (1) • Should annuitization be mandatory? • Solves myopia and adverse selection, ensures lifelong income, but inflexible, some people worse off, especially if unhealthy • Compromise: require deferred annuity up to poverty line? • Require price-indexed and joint pensions? • Insures against inflation, protects widows (pocket of poverty) • Can’t inflation index unless govt. issues indexed bonds for insurance company investment • Each extra protection costs, must consider trade-offs • Should variable annuities be permitted? Required? • Greater expected income and uncertainty • Who can best bear investment and longevity risks—insurance companies, individuals or government? Share risks?

16. Canada US Aus-tralia UK-nominal UK-price indexed Chile-price-indexed Level SPIA 740 733 700 727 522 820 10YG 702 658 691 761 Joint SPIA 664 648 543 642 438 731 Escalating SPIA 564 Monthly payout for immediate annuity, man age 65, 100,000 premium, 1999

17. Policy issues (2) • What are allowable risk categories? • Gender? income? health? DNA? • Insurance companies will try to differentiate, difficult • Risk differentiation avoids undesired redistributions, adverse selection, unstable outcomes for companies • But may violate social or legal norms (unisex? rce?) • If no differentiation--creaming, mandatory, monopoly? • Can insurance companies do cost-effective job? • High MWR in many countries, costs covered by investments, annuity companies grew rapidly in Chile • But problem if unhealthy, want flexible income for emergencies, willing to take investment risk • Problem for small economies and accounts (Kosovo) • Use public or private provider, retail market or competitive bidding procedure?

18. Canada US Australia UK-nominal UK-P indexed Chile-P indexed Annuitant Annui-tant Annuitant Annuitant Annuitant Annuitant Individ-ual 98.1 99.5 101.3 97.7 88.7 99.5 Joint 98.0 97.0 98.8 98.7 88.0 101.3 MWR for men, age 65, 1999 (based on common mortality improvement factor)

19. Other problems and policies • Consumers uninformed, wide variation in payouts and MWR’s among insurance companies • Chile now requires electronic disclosure of bids • Singapore distributes price and product info twice yrly • Payouts vary by date, as interest rates vary • In Chile payouts fell 15% 1999-2003, another 15% 2003-2005, due to falling interest rates • In UK workers can annuitize anytime age 60-75. But apprehension that wrong date will be chosen. • Possible solution—gradual annuitization

20. Lessons for other countries: Policies shape retiree payout choices • Important to plan payout stage. Regulations and guarantees shape options, incentives and behavior of retirees and insurance companies • In Chile these policies prohibit most lump sum distributions, require price indexed & joint pensions, give government guarantee to annuities and competitive advantage to insurance companies • 2/3 of retirees chose life-long income through annuities • Insurance industry grew to meet and stimulate demand • Given costs, which protections should be required? • In countries with fewer payout restrictions, less annuitization, even if higher MWR

21. Need for careful regulation • Regulators must ensure that companies have sufficient reserves to pay promised annuities • What happens if people live longer than expected? If interest rates fall further? • Are reserves large enough? Is portfolio too risky? • Is MWR in Chile too high to be sustainable? • Equitable case in UK: promised high return but didn’t reserve enough, so went bankrupt when r fell • In low income countries insurance industry, mortality tables, financial instruments are weak • Use international insurance company & regulator? • Coordinate payout rules with safety net. If retirees use up their money quickly or companies become insolvent, this will become large fiscal liability