Payout choices in Chile: what are they are why? (and comparisons

with Singapore)by

Estelle James,

2

Why Chile?• Chile has had individual accounts for 22 years,

therefore many retirees• What choices do retirees make during the payout

stage?• How do producers respond?• How do regulations influence this behavior?• What problems have arisen?• What can other countries learn from Chile?

– Regulations determine choices—policies matter so must be chosen carefully

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Singapore also has long existence—main contrasts

• Accumulation is 10-12 times annual wage in Chile and pension/wage > 50%, much larger than in Singapore, despite lower contribution rate (10+3%)—due to higher rate of return (10% real) & no withdrawals for housing

• Lump sum payouts not permitted unless RR>70% (permitted in Singapore above Minimum Sum)

• High rate of annuitization—65% (lower in Singapore)• Annuities are required to be price indexed, fixed rate-- provide

inflation, longevity and investment insurance. (Participating and non-indexed in Singapore)

• Survivors’ benefits required during accumulation stage and joint annuities during payout stage, to protect widows (widows can keep own pension + survivor’s benefit)

• Minimum pension guarantee for low earners (not in S.)

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• Therefore greater protection for very old, especially women, in Chile at little extra cost to state. Most of costs are covered by young retirees and husbands. This protection is lacking in Singapore

• Annuitization plays a key role in providing lifelong security in Chile, much weaker role Singapore

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2 key choices in Chile: 1) Early versus normal retirement

• Normal retirement age is 65 for men, 60 women• Early retirement permitted if pension>50% wage, 110%

MPG (start withdrawing, may work without contributing)• Early retirement could be bad because money gets used up

quickly, retirees may stop working• But my work shows that most of them annuitize so money

continues and many continue working; lfpr of older men has increased since 1982

• Regulations have facilitated early retirement, perhaps too much and may put burden on MPG. But early retirement has also helped sell annuities, which mitigates this effect

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Regulations facilitate early retirement

• Employers and workers can put extra money into retirement accounts to qualify

• Years with no earnings reduce own average wage• Recognition bonds tradeable, can be sold to

insurance companies as part of premium• Additional funds given to affiliates who retired in

first ten years of system• Early retirees can start withdrawing, but can

continue working without contributing• Therefore 60% of all retirees are early retirees

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Key choices: (2) Annuity vs. programmed withdrawal (PW)

• Annuity: steady income stream with investment and longevity insurance. No bequest. Fixed rate annuity with price indexation required

• PW: money stays in AFP, no insurance, worker’s account gets investment earnings, payout formula set by regulator, front-loaded, heirs inherit balance

• 2/3 of all retirees have annuitized, including 85% of early retirees

• Annuity industry has grown from zero to premiums > US$1billion, reserves>$10 billion. Annuity business far > than life business.

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% of total policies that are early retirement, 1988-2002 (stock)

0%

10%

20%

30%

40%

50%

60%

70%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

years since 1988

% e

arly

retir

emen

t

% early retirement

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Percentage of policies that are annuitized, 1988-2002

0%

20%

40%

60%

80%

100%

120%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

years since 1988

% o

f pol

icie

s an

nuiti

zed

normal old age

early retirement

total retirement

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Why so much annuitization and why tied to ER? Regulations give edge to

insurance companies• Initially only insurance companies could buy bonos• Insurance companies can pay commissions to

independent brokers while AFP’s can’t• Insurance companies can make loans to help workers

meet early retirement criteria but AFP’s can’t• Insurance companies keep spread (return earned-

return earned) so seek retirees with large assets, help them retire early-- eligibility, information, paperwork. Workers buy annuities in return. ER is the carrot that sells annuities.

• AFP’s must pass entire investment return back to retirees, all fees must be explicit. Fees and profits higher from contributing workers, don’t market ER

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In addition, competition leads annuities to be a good deal

• MWR = EPV of lifetime • MWR = 98% at age 65 using risk-free term

structure—1999 and 2003. (MWR>100% in Singapore 1999 but lower now)

• Unusually high MWR for indexed annuities—many indexed investment instruments available.

• Insurance companies cover costs out of spread between risk free rate and rate they earn on more diversified portfolio—around 1.4% 1993-2003.

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Monthly payout

MWR-RV98, period

MWR-RV98, cohortized

MWR-RV85- regulator

Age 65, SPIA

7.08 98.1 101.2 93.5

Age 55, SPIA

5.46 94.1 97.6 90.1

Joint (65/60/60%)

5.89 97.7 100.8 94.6

Age 65, SPIA, risky rate (r+1.4%)

7.08 88.1 90.5 84.3

Female, 55, SPIA

4.81 89.9 92.9 87.4

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Who doesn’t annuitize? Impact of minimum pension guarantee (MPG)

• Every worker with 20 years contributions is guaranteed a minimum pension=MPG

• MPG set in nominal terms but reset each year; de facto linked to wages, around 25% average wage

• Jumps up 9% at age 70• Reduced for early retirees• Also applies to survivors benefits• If PW falls below MPG, worker must spend down

accumulation, then government pays pension.• If annuity falls below MPG, government tops it up

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MPG growth vs. real wage grow th, 1981-2002

0

20

40

60

80

100

120

140

160

180

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

years

MPG

& w

age

inde

x

MPG index<70

MPG index>70

Real w age index

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Workers with small accumulations don’t annuitize—get MPG

• If original annuity < 100% MPG, must take PW• Moral hazard: if original annuity > MPG but small, PW

maximizes lifetime income (front-loaded payouts) and also gives bequests to heirs. But payout can’t fall below MPG, so worker doesn’t need annuity insurance

• Workers with large accumulation can lose from PW because MPG floor is far below their annuity

• Therefore we would expect that: – workers with small accumulations retire at normal age with PW– those with large accumulations retire early with annuities.

• This is exactly what we find

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payouts for annuity vs. PW for small accumulation

0

2

4

6

8

10

12

1 3 5 7 9

11 13 15 17 19 21 23 25 27 29 31 33 35years since retirement

CH U

F

PW-no MPG annuity-no MPGannuity with w-linked MPGPW with hi'r exp. r and w-linked MPG

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annuity vs. PW payouts for large accumulation

0

2

4

6

8

10

12

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35

years since retirement

CH

UF

annuity with p-indexed MPG

annuity with w-linked MPG

PW (RV85, exp. R=6%) with w-linked MPGPW (RV85, exp. R=6%) with p-indexed MPG

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Evidence

• Most (85% of) early retirees annuitize • Average size pension for early retirees is

twice that of normal age retirees• Majority (66%) of normal age retirees take

PW and their pensions are at MPG level. • Long run fiscal implications of MPG.• So guarantees can have a negative impact

on annuitization

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Do retirees with poor health buy annuities? Adverse selection

• Some pensioners with large accumulations take PW. Do they have shorter expected mortality?

• We don’t have data on mortality of PW, but we have for annuitants.– A/E deaths much lower in first few years of exposure but rises in

later years– A/E much greater for those taking annuities with guaranteed

payment periods rather than simple annuities, especially in first few years of exposure

• So some private information seems to exist about short run mortality probabilities and it influences behavior, but this effect disappears in long run.

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Lessons for other countries: 1) lifelong income security

• In Chile policies that prohibit most lump sum distributions and pre-retirement withdrawals, limit choice to annuities vs. PW, and require price indexed and joint pensions provide high level of income security for the old—especially valuable to women who are majority of very old, with no cost to state. Sharp contrast to Singapore

• 2/3 of pensioners have annuitized; insurance companies supply annuities and increase demand

• Guarantees and regulations create incentives that shape behavior. Pensioners and providers respond in predictable ways; so important to choose good policies

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2) Caveats• In Chile incentives for annuitization include aggressive

marketing by insurance companies offering ER & regulations giving them competitive edge (demand might be much smaller otherwise);

• Many workers will choose early retirement if allowed, so conditions must be chosen carefully;

• Great uncertainty re mortality and interest rates-problem for insurance companies under annuitization, government & pensioners under PW (or participating annuities)

• MPG discourages annuitization for small accounts. Payout conditions must be coordinated with safety net provisions, to avoid moral hazard and unexpected public liabilities

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Singapore--issues• Why so few annuitants? (In absence of DB or

MPG would predict more annuitization, but small size of accumulation may deter this)

• Aggressive insurance company marketing?• Should price-indexed annuities be provided?• Why no protection for women re survivors’

benefits, joint annuity and inheritance rules? (Very old women will pose problem in future)

• Potential problems caused by low interest rates:• Any losses on old policies? • How are administrative costs covered?• Given return of capital requirement, how is annuity

financed for long-livers?

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Singapore-questions (2)

• Any regulatory issues re participating annuities?• Do consumers understand and trust?• What disclosure requirement?• How much discretion ins setting payouts?• Are companies less interested in managing interest rate

risk by AL matching, or reducing mortality risk by building cohort tables?

• Other key issues in Singapore?