Payout policies and choices in Chile (and some comparisons)

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Payout policies and choices in Chile (and some
comparisons)

• by
• Estelle James
• Prepared for World Bank HD week,
• November 2006

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The payout stageoften 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

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Rules of the gamepayouts constrained in Chile

• Workers are required to save for their old age
  because of myopiaso 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 gt70
  workers average wage

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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
  menprotects 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)

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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
  taxand many do so (lfpr of older men has risen)
• 2/3 of all pensioners have annuitizedvery 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?

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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 optionsannuity 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 AFPs cant
• Guarantees
• Government guarantees annuity (MPG 75 gt MPG)

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And private insurance companies market
aggressively

• Enter industry and compete for captive clients
• Industry grew rapidly--Reserves grew from lt .5
  billion 1985 togt14 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 timeER is the carrot
• Therefore workers who retire early are most
  likely to annuitize85 of early retirees, 35
  normal retirees
• Companies pay high moneys worth ratio (MWR) to
  attract customers

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MWR100 on price-indexed annuities

• Moneys 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 portfoliocovers
  their costs
• In UK MWR98 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 indexedmore inflation risk, lower
  return

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Contrast payout policies in Chile with UK,
Australia, Fiji

• UKPart 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 dont have to be joint or price-indexed
• Little annuitization over many years
• Australiafew restrictions, practically no
  annuitization
• Fijiannuities, GW and lump sums allowed
• Annuities paid by public institution on very
  favorable terms (MWR 200)private companies
  cant compete
• 25-30 retirees have annuitized

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Lower annuitization in UK, Australia and Fiji
because

• UK
• Government provides flat benefit to most retirees
  means-tested benefit to manyso less need for
  annuity
• Voluntary contributionoptions 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

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But all Chileans do not annuitize

• Chile offers minimum pension guarantee after 20
  years contributions (25-27 average wage).
• If original pension lt 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 (gt5MPG)
  self-insure through GW, keep bequest inv rights
• For workers in-between, MPG floor is far below
  annuity they could affordlittle protection. They
  choose annuity to get longevity insurance.
• Average annuity nearly double average GW. Probits.

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Do unhealthy avoid annuities? Limited evidence of
adverse selection

• Adverse selection means workers in poor health
  who expect to die young dont 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 exposureadverse 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

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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)
• Cant 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
  risksinsurance companies, individuals or
  government? Share risks?

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Monthly payout for immediate annuity, man age 65,
100,000 premium, 1999
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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?

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MWR for men, age 65, 1999 (based on common
mortality improvement factor)
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Other problems and policies

• Consumers uninformed, wide variation in payouts
  and MWRs 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 solutiongradual annuitization

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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

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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
  didnt 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