Ebook Are Annuities Value for Money? Who Can Afford Them?
Currently, and in most countries, the government, through the first pillar of the social security system, insures retirees against inflation and longevity risk. At retirement, the state pension that each retiree is entitled to receive is computed based on his lifetime earnings. The retiree is entitled to receive this pension for as long as he lives, and in this way obtains insurance against longevity risk. In addition, and in most countries, nominal state pensions are indexed to a measure of consumer prices such as the consumer price index (CPI), so that the real purchasing power of retirees is relatively unaffected by inflation movements.
In recent years, economists and politicians in most Western countries have become increasingly worried with the sustainability of the current social security system and its current level of benefits. The ageing of the population has led to a dramatic and unsustainable increase in liabilities.
Consequently the second and third pillar of the social security system, which are mostly funded systems, have become increasingly important in financing households’ retirement. In a funded system, each person accumulates savings in a retirement account which will become liquid at retirement age.
However, accumulated financial wealth that is run down at retirement may not be a good alternative to state pensions, because it lacks some of the insurance features of the latter. A portfolio of financial assets does not necessarily provide insurance against inflation risk and longevity risk. Whereas in certain countries retirees may invest their financial portfolio in inflation-indexed bonds and in this way insure themselves against inflation risk, it may be harder to obtain insurance against longevity risk.
As demonstrated in the pioneering work of Yaari (1965), the optimal choice of a non-altruistic individual is to hold all his assets on actuarial notes, whenever the probability of death is positive. This result is driven by the fact that the annuity system reduces the inefficiency created by the uncertainty of the time of death, as well as the fact that actuarial notes pay a higher interest (market interest rate plus a mortality premium) conditional of being alive.
Applying this result, one alternative is for individuals to use their accumulated financial wealth to purchase an annuity upon retirement. If the annuity is inflation-indexed it will insure the retiree against inflation movements in addition to longevity risk. Annuities are offered in the private marketplace in many countries, including the United Kingdom. Thus, it seems, the features of state pensions may be replicated in the marketplace, at some cost, for households who wish to do so.
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