A conventional life annuity enables an individual to convert a stock of wealth (paid to a life insurer in a single premium) into an income that is received with certainty until the end of life. The advantage of such an annuity is that it insures the individual against out-living their wealth in the event of living longer than expected. Annuities represent the decumulation phase of a Defined Contribution (DC) pension scheme, and have been available in a variety of contexts since Roman times. They are of increasing importance in the UK because they form a large and growing part of the pension system.
As recently as a hundred years ago, nearly all workers would expect to earn a wage for almost their entire life and would usually only withdraw from the labour force as they became unable to work due to ill-health. Throughout the 20th Century this has gradually been replaced by a model whereby individuals stop working some time before the end of their life and while still relatively healthy. In many cases this long period of retirement would have been financed by a Defined Benefit (DB) occupational pension scheme, which involved the employer, albeit indirectly, continuing to pay a pension to the retired worker.
Greater mobility in labour markets has resulted in demand for more flexible pension provision from employees and greater longevity has made occupational DB pensions increasingly costly for employers (although this was masked by high equity returns towards the end of the 20th Century). Increasingly, therefore, workers have to save for a pension through a DC scheme. DC pension schemes first became a realistic option for retirement income with the 1956 Finance Act, which gave tax relief to such schemes but in return required the funds to be converted into an annuity at, or soon after, retirement. In the 1998 Green Paper Partnership in Pensions, the UK government re-emphasised its commitment to individual DC pensions via stakeholder schemes as a means of providing income in old-age.
The 1956 Finance Act introduced two major changes in the UK annuity market: the expansion of the existing annuity market (now called the ‘voluntarypurchase’ market) due to a more favourable tax treatment of the capital sum; and the creation of a ‘compulsory-purchase’ market, selling annuities to those individuals who had taken out a tax-efficient DC personal pension. The prices of annuities differ in the two markets, mainly because average life expectancy of people buying these two sorts of annuity is different.
It is possible to project the demand for compulsory-purchase annuities from existing private pension and estimates by the Association of British Insurers (ABI) suggest substantial increased demand in the next decade: partly due to the increasing number of personal pensions, taken out since 1988, maturing; and also due to the switch from occupational DB to DC schemes.
Although the proposed A-day changes will reduce the compulsory annuitisation constraint to some extent, the magnitude of this change will be small and consequently it will still be important to have a well-functioning annuity market to provide pension income. This survey reviews the theoretical and empirical literature on the demand, supply and regulation for annuities to provide evidence for further policy review.
Contents
Acknowledgements
The Authors
Summary
1 Introduction
2 History of annuities and the UK context
3 Annuity demand theory
- 3.1 The role of annuities in consumer choice
3.2 Annuity demand when there are two periods
3.3 Annuities when there are many periods
4 Description of annuity markets
- 4.1 Types of annuities
4.2 Data on annuity rates
4.3 Money’s worth calculations
4.4 Theory of adverse selection in annuity markets
4.4.1 The Eckstein-Eichenbaum-Peled approach
4.4.2 The adverse selection models of Abel and Walliser
- 4.5 Evidence of adverse selection
4.6 Demand for annuities
5 Reasons for the ‘annuity puzzle’
- 5.1 The role of imperfect annuity markets
5.2 Necessary expenditure early in retirement
5.3 The option value of deferral
5.4 Social welfare payments
5.5 Habit formation
5.6 Behavioural factors
5.6.1 Cumulative prospect theory and loss aversion
5.6.2 Additional psychological considerations
6 Supply of annuities
- 6.1 Market shares of annuity business
6.2 Regulation of annuity providers
6.3 Managing the annuity liabilities: longevity risk
6.4 Interest rate risk and bond markets
7 Conclusions
References
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