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Annuitisation as a gameSelected problems of the II pillarof the new Polish pension systemthat may be relevant for Bulgaria

By Wojciech Otto

Faculty of Economics of the Warsaw University

September 2006

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The Game• At the contribution phase 7,2% of earnings (until the ceiling

of 250% of average wage) are transferred to individual member’s accounts in an Open Pension Fund– During this phase investment risk is borne almost fully by members– Savings are inheritable (OPFs bear no mortality risk)– A member can change a Fund

• At retirement a member converts accumulated savings into life annuity (other admitted product ?), making choice as to:– A product– A provider (if there is more than one)– Deferring the decision (if admitted to)

• After retirement the game for the retiree is over (classical life annuity is an irrevocable contract)

• The game is not known in most existing pension systems– Because there is single annuity provider, or:– Because both phases are serviced by the same Pension Fund, and the

choice of the provider is made by choosing the employer

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Major players and other agents

• Annuity Providers (AP) – (life insurers?)• Providers of planned withdrawals (OPFs? banks?)• Members – (decision makers at retirement, passive

beneficiaries afterwards)• The State (and the taxpayer behind it) as:– Regulator (mechanism designer)– Supervisor (of compliance with rules)– Guarantor of solvency of providers– Sponsor of the Guaranteed Minimal Benefit– Issuer of public debt (bonds etc.)

• Other players involved in the financial and capital markets

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Life Annuities: sources of risk• Investment risk– Market risk, provided AP invests in risky assets– Could be overcome provided AP invests in risk-free

instruments at the cost of:• Canalizing AP investments into public debt• Lower rates of return (and thus lower annuity rates)

• Longevity risk– Individual risk – given the lifetime distribution

(diversifiable on the level of individual AP)– Error of prediction of the lifetime distribution of the

cohort - (non-diversifiable)– Non-representativeness risk (the structure of portfolio

of an AP in respect of risk factors can differ from average)

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Non-representativeness risk

The source of risk unknown in most pension systems, where providers of pension benefits do not compete for members who choose among them at retirement

• Temporary component: national life tables are not adequate– collecting information in first decades of the new system

would help to built adequate life tables

• Permanent component: the uncertain structure of clients as a result of distortions of the market, caused by suppressed differentiation of annuity rates by some risk factors

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Should annuity rates differ by risk factors?

• Age (widely accepted)• Gender (hot public debate)• Region, profession (rather contested, not

much talked about)• Genetic factors (contested)• Marital status, accumulated wealth (not

debated)• Individual health status (implicitly

contested, but almost ignored in the debate)

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Prohibition of gender-specific rates• Misunderstandings concerning „unisex tables”• Catching gender indirectly by age (provided

retirement ages are gender-specific)• Distorted choice of a product: driven by attempts

to evade taxation and to catch subventions– example: males choose programmed withdrawals (if

admitted), females choose life annuities• Distorted competition between AP – Enormous acquisition costs justified by the size of the

loss on contract with a female and the size of the profit on contract with a male

– The risk can be reduced by pooling – that might induce concentration on the market, tacit collusion of providers etc.

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Repealing free choice of a provider?• One AP, auctions for management of assets • Many APs, central auctions for subsequent cohorts

– one winner for all products– one winner per one product

Effects of the size of contracts:– Collusion of providers almost certain– Political risk – a lost goal of the reform– For whose favours AP would compete?

• Auctions run by each OPF for the cohort of retiring members - result:– instead of APs, now OPFs are motivated to compete for as large

share of males as possible among members who will retire soon

Practical problems:– How to set capital requirements for tenderers?– How to avoid delays when a looser protests the verdict?

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Other solutions

• Joint annuity for a couple:– Does not solve the problem of those who are single

– It is unfair to impose buying joint annuities on couples with large age difference, short wedlock etc.

• Organized electronic auctions for individual retirees (Chilean solution)– Designed to make sure that retiring persons have a

good overview of provider’s offer

– Probably cannot efficiently serve as a measure to prevent the retiring person from communicating private information to the provider

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Taxing males, subsidizing females

• Redistribution from males to females is common in almost all existing mandatory pension systems, but is hidden

• Is it necessary to hide it also in this case?

• Even if hidden to the public, should be designed carefully in order to avoid ill effects

• In fact we have to decide what is a gender of savings– should we tax savings accumulated by a male, or rather:

– savings that are devoted to purchase an annuity for a male?

• Possible ill efects that should be avoided– incentives for divorce

– non-equivalent treatment of couples with the same total savings but different proportions etc.

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Individual health status

• Private information on this factor is assymetric: few expect to live quite short, others know that „everything’s OK”

• Allowed underwriting produces incentives to retirees with severe health problems to „sell their poor prognosis”

• Prohibited underwriting in the extreme cases (when the poor prognosis coexists with strong bequest motive):– On the side of a member: might trigger the „deferral game” – the

winner is the one who has successfully died before reaching the age when annuitisation is obligatory

– On the side of a provider: produces strong incentives for aggressive acquisition (among patients in oncological hospitals etc.)

• Signalling the private information by the choice of a product (if there is a choice) cannot be prevented– If there is a choice of the product, those who choose well-indexed life

annuities would be expected to live longer than average– Some choice at least in respect of time of retirement cannot be avoided

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Potential solutionsWhen health status underwriting is prohibited, we should

introduce the „cushion” that makes the transition from the contribution phase to the payout phase gradual

• A possible solution: a life annuity offers additionally the benefit paid to heirs on death of the annuitant. The amount of benefit decreases linearly, starting from the total amount of savings at inception, and reaching zero n years later– This should reduce incentives for aggressive acquisition on the side

of providers, if such product is mandatory– Motivations to enter the „deferral game” on the side of a member

are reduced (even if the additional benefit is optional)– Both effects should be sufficient even for small n, as usually poor

prognosis means high mortality in the nearest few years only– The additional benefit should reduce the annuity rate only slightly

provided n is small, and:– members are obliged to buy such annuity before reaching the

upper age limit that is not too distant from 65.

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annuity payments per 100000 single premium

200

300

400

500

600

700

8000

30 60 9012

015

018

021

024

027

030

033

036

039

042

045

048

051

054

0

number of months to expiry of the indiv. account

mon

thly

pay

men

t

males aged 65females aged 60

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Assumptions underlying the graph

• Stylized Bulgarian mortality tables– averaged 2000-2003 and smoothed

• Commission on single premium 1%– allowance for acquisition costs

• Commision on monthly payments 0,5%– allowance for administration costs

• Annuity payments linked to inflation rate• Real rate of return 0,1% monthly• No profit margin, no risk premium