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The Role of Annuity Markets in Financing Retirement.

He finds that the basic tenets of the theory are confirmed, as married people with higher risk aversion, longer life expectancy and a smaller fraction of pre-annuitised retirement wealth tend to prefer annuitisation. Butler and Teppa 13 perform the same exercise as Brown, 14 but using actual choices instead of intentions: in particular, they consider administrative data about the annuitisation choices at retirement of Swiss workers enrolled in ten employer-sponsored pension plans.

With respect to survey questions, they are administrative data have their pros and cons: they are certainly more reliable; but they usually provide much less information about the worker.

Their results are in line with Brown's. The paper by Hurd and Panis 16 is also relevant: its methodology and results are analogous to those of Brown, and Butler and Teppa. Hurd and Panis use HRS data from the five waves between and However, each of them suffers from at least one of the following limitations: 1 they do not study a representative sample of the underlying population; 2 they observe annuitisation choices or intentions but cannot disentangle the demand from the supply of annuities, as they do not control for annuity prices; and 3 they either do not observe the fraction of annuitised wealth held outside private pension plans 19 or they measure it very imperfectly.

The empirical approach adopted in this paper addresses these drawbacks. First, we use a sample which is representative of a large subgroup of the Italian population namely, heads of household , and constitutes an important component of the Italian labour force. Second, experimenting with different annuity prices enables us to elicit the shape of the annuity demand schedule.

Third, making the total amount of annuity benefits explicit solves the problem of controlling for differences in annuitised wealth. Our paper also contributes to the literature that explores the influence of financial literacy on behaviour. The rest of the paper is organised as follows: The next section provides a very short outline of the Italian pension system, which can be helpful to put our results in perspective; in the subsequent section we describe our data and show some preliminary univariate result; in the penultimate section we perform a more formal multivariate analysis.

The final section discusses some implications of our results and offers some tentative conclusions. The Italian pension system has several peculiarities that make it different from those of the U. In Italy, retirement income mainly comes from the public pay-as-you-go pension system, which is based on two main pillars. The size of the benefit increases with the amount of contributions paid by the worker during his or her career. This scheme has fairly complicated rules and is the result of a lengthy reform process started in the early s.

Apart from State-provided pensions, there are several private pension plans.

The Role of Annuity Markets in Financing Retirement

Enrolment in these plans is on a voluntary basis, 27 even if there are fiscal incentives for those joining, and in the case of employer-sponsored plans, most employers grant matching contributions. Assets and enrolment in these private pension schemes, although slowly increasing, are low with respect to international standards. At present, assets under management of Italian pension plans amount to 5.

We use the survey data to construct an indicator of the preference for annuities, which is a discrete variable taking the value of 1 for respondents who say no to the annuity even at the lowest price 60, ; 2 for those who prefer the annuity at the lowest price but reject it at a higher price; 3 for those who prefer the annuity at the middle price 80, but will not buy it at the highest price; and 4 for those who opt for the annuity even at the highest price , Demand for annuities—Participants who prefer the annuity to the lump sum heads of household 65 or younger.

As a first step, we look at simple unconditional correlations between our measure of annuity preference and some individual and household characteristics which economic theory suggests are potentially relevant. In managing your financial investments, would you say you have a preference for investments that offer: a Very high returns, but with a high risk of losing part of the capital; b A good return, but also a fair degree of protection for the invested capital; c A fair return, with a good degree of protection for the invested capital; d Low returns, with a low risk of losing the invested capital.

You will receive the money in a year's time. However, if you give up part of the sum you can collect the rest of your win immediately. To obtain the money immediately would you give up 20 per cent of your win? Overall, our data question the assumption that households are able to make the annuitisation decision on the basis of a full evaluation of the effects and likelihood of all relevant future events, maximising the expected discounted value of present and future utility. This is consistent with previous evidence showing that many individuals are not able to do even simple economic computations, and lack knowledge of even the most basic economic concepts.

The negative correlation between risk aversion and annuity demand may also be due to behavioural biases. In particular, Brown et al. Imagine leaving 1, euros in a current account that pays 1 per cent interest and has no charges. Imagine that inflation is running at 2 per cent. Do you think that if you withdraw the money in a year's time you will be able to buy the same amount of goods as if you spent the 1, euros today?

Which of the following investment strategies do you think entails the greatest risk of losing your capital? These two questions were first used in the HRS survey. Being able to understand inflation risk is crucial to evaluate correctly whether an annuity is better value than a lump sum. Indeed, people who respond incorrectly to the first question may not understand that the real returns of some asset classes such as a simple bank deposit are dented by inflation: this might induce them to underestimate the value of a real annuity such as the one offered to our respondents.


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Our data suggest that this is actually the case. The sign of the relationship between knowledge of the risk diversification principle and annuitisation is instead less straightforward. On one side, those unable to understand the principle of portfolio diversification are unlikely to profit from investing in financial markets: for them, the value of a lump sum which depends on how it is invested during the post-retirement period might be low relative to the value of the annuity. Therefore, if they are aware of their financial ignorance, they should prefer the annuity.

On the other side, a minimum degree of financial sophistication is also required in order to understand the value of annuitisation as a way to avoid longevity risk. As a matter of fact, at least looking at simple correlations, in our sample, annuity demand is lower for people answering the risk diversification question correctly. The point that the relationship between financial knowledge and propensity to annuitise can go in either directions has been stressed by Brown and Agnew et al.

Which of the following statements concerning supplementary pension schemes do you believe to be true? Those who perform badly in this test of pension literacy appear less likely to opt for the annuity. Finally, as another proxy for the degree of financial education, we also added a dummy taking value of one if the individual owns stocks. In this section, we assess the extent to which the simple correlation results highlighted above are robust to a more formal multivariate analysis. Let us indicate Y i our dependent variable the degree of annuity preference of individual i.

We estimate the model, as usual, with maximum-likelihood. Demand for annuities: Ordered probit model heads of household aged 65 or younger. Marginal effects on the probability of rejecting the annuity even at the lowest lump sum. Marginal effects on the probability of choosing the annuity even at the highest lump sum.

The effect is particularly sizeable in the case of wealth and schooling. The probability of rejecting the annuity even for the lowest lump sum is 6. Concerning financial literacy, the effect on the probability of accepting the annuity in exchange for the lowest lump sum is also sizeable. The annuity demand appears to be quite elastic with respect to prices. It is particularly so at high prices and for the most vulnerable people: it is 33 per cent for our benchmark, 40 per cent for a person belonging to the lowest wealth quartile, 41 per cent for one having only a primary school diploma, 32 per cent for a person with low pension literacy, and arrives at 51 per cent for a person who has all these three characteristics at the same time i.

First, we check that the results of the previous section do not change if we enlarge the sample to consider all the respondents therefore including those above As a second exercise, we restrict the sample to respondents in the 51—65 age bracket. This is potentially interesting because for these individuals the values of most variables should be very close to the subjectively expected values at retirement. Demand for annuities: Ordered probit model heads of household between 51 and Demand for annuities: Ordered probit model controlling for the discount rate heads of household aged 65 or younger.

To summarise, across all the samples and specifications that we used, the importance of wealth, schooling and financial literacy is confirmed. Prima facie , the annuity demand schedule that we estimated from our survey data is in contrast with the thinness of the Italian annuity market. In fact, as discussed in Guazzarotti and Tommasino, 51 the number of outstanding annuity contracts is very small. However, it is expected to rise substantially in the future, since at present about 24 per cent of the workforce in the private sector is enrolled in complementary pension plans which, under Italian law, require the conversion of at least half of the accumulated capital into an annuity at retirement data about pension plan enrolment are provided by COVIP, the Italian pension regulator.

In particular, Guazzarotti and Tommasino 53 estimate that in the Italian market the money's worth ratio i. In turn this would imply, given our estimated annuity demand schedule, and given the characteristics of our sample, a probability of opting for an annuity equal to 26 per cent. Of course, we do not claim that these back-of-the-envelope calculations count as a validation of our estimates. Our point is instead that: 1 notwithstanding their obvious limitations, survey answers to hypothetical choices have some potential in explaining real-world behaviour; and, 2 when interpreting actual choices, it is crucial to distinguish the role of annuity demand from the role of supply-side characteristics.

In this paper, we measured the strength of annuity demand at retirement using a sample representative of the Italian heads of household, adopting an empirical strategy able to control for differences in annuitised wealth, prices and other product characteristics. On average, we find that there is a strong demand for annuity products, at least compared with the demand we observe today, at current market prices. However, our empirical analysis highlights that this statement requires important qualifications.

These individuals are also those who, without an annuity, are more likely to end up with insufficient resources if they happen to live longer than they expected. It is quite likely that the annuity demand of these vulnerable subgroups is sub-optimal, either because they do not understand the importance of insuring against longevity risk, or because they are prevented from taking advantage of longevity insurance due to stringent liquidity constraints. How can this be done?

Policies that prevent annuity prices from increasing too much above their actuarially fair benchmark are the obvious first step. Indeed, there is by now ample evidence that annuity prices are quite high. For example, by promoting the timely release of accurate life tables or by providing adequate amounts of very-long-term bonds and longevity bonds. In particular, governments should promote not only programmes aimed at providing basic financial skills, but also specific programmes concerning pension-related topics, in order to raise awareness of retirement needs and longevity risk.

As a policy of last resort, the minimum fraction of pension wealth that has to be annuitised at retirement could be mandatorily increased. This policy would probably improve the welfare of investors with behavioural biases. On the other hand, it also entails costs, as some individuals could turn out to be over-annuitised. Yaari More recently, see Davidoff et al.

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They only have to bear the aggregate component, that is, the risk of unpredicted changes in the average lifespan Visco, This is true if we abstract from asymmetric information which creates adverse selection problems and administrative costs, which are of course very important real-world phenomena. A thorough and up-to-date theoretical treatment of these aspects can be found in Sheshinski, op. References to the empirical research can be found below footnote Feldstein and Siebert ; Diamond and Orszag A similar question is included in the wave of the U.

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It seems also a quite reasonable assumption for the medium and the long run. Indeed, 3 per cent is the figure used by European Union countries for their long-term forecasting exercises see e. European Commission, By contrast, there has been a lot of theoretical research to determine optimal annuity demand. For instance: Ameriks et al. Surveys of the development of annuity markets around the world can be found in James and Song , Mackenzie , and Cannon and Tonks Brown, op.

Respondents were asked if they had done anything with a pension right since the previous wave. Hurd and Panis, op. Moreover, he has to assume that the fraction of wealth annuitised at retirement is equal to that observed at the time of the survey. He also assumes that all retirement wealth in DB plans will be annuitised. We do not discuss here disability pensions which are about 25 per cent of the total pension treatments.

Overall, about 90 per cent of old-age pensions are paid under the contributory scheme. The computation of benefits in the contribution-based pillar is also quite complex: due to the gradual phase-in of the pension reforms, different cohorts of workers are subject to different rules. However, focusing on those with more than 15 years of contributions in , which have constituted in the past and will still constitute for several years to come , the vast majority of those entering retirement, in pension benefits were computed as a fraction of the average of their wages of the last 10 working years.

The Italian notional defined-contribution system is discussed in Franco, op. As opposed to what happens, for example, in the U. Besides financial wealth, most individuals 78 per cent own the house in which they live. Moreover, under the Italian pension law there is no difference in the taxation of the lump sum and of the annuity: in both cases, pension wealth at retirement is subject to a proportional tax of 15 per cent.


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  • Therefore, we should not be concerned with the tax issue. These results confirm similar findings by Butler and Teppa, op. Individuals who answered a were considered low risk aversion individuals; those who answered b or c were considered medium risk aversion individuals; those who answered d were considered high risk aversion individuals.

    Income and wealth are considered as dummies to pick up possible non-linearities, for example due to liquidity constraints. The question was put to a randomised subset about 50 per cent of the total of our sample. See also Warner and Pleeter for a similar result. We used answers to the question to build an ordinal proxy for the discount rate. Lusardi and Mitchell, op. Brown , and Agnew et al. As suggested by Inkmann et al.

    In all the reported estimations, we use survey weights to ensure that the results are valid for the underlying population. The use of weights in order to correct for unequal probabilities of selection among sampling units is discussed, among others, in Deaton The weighting scheme adopted in the Bank of Italy Survey is explained in detail in Faiella and Gambacorta In an early version of the regressions we added real estate wealth among the regressors but, contrary to financial wealth—which is more liquid—it is never significant, so we dropped it from our preferred specification.

    Income and wealth quartiles are ordered from the poorest the first quartile to the richest the last quartile. This individual is male, married with children, in good health, with an average degree of risk aversion, and is over 60 years old. Of course, the choice of the benchmark is quite arbitrary, and it only matters as a way to clarify and show the results of the multivariate analysis.

    As in the previous exercise, all these individuals are, in all other respects, similar to the benchmark. One of the reasons for this is that both in general and in our data the correlation between health and income and the correlation between health and wealth are higher for older people than for younger people. Guazzarotti and Tommasino Contributions to the plans are not compulsory; however, a reform implemented in has significantly strengthened the incentives to join employer-sponsored pension plans in particular, an automatic enrolment provision has been added.

    Cesari et al. Guazzarotti and Tommasino, op. At the moment, the Italian annuity market is very small Guazzarotti and Tommasino, op. The amount of annuity purchases, either by individuals or via pension funds, is small. While exact figures concerning single-premium immediate annuities i. Even if this number is increasing almost a third of outstanding contracts were signed in , in the — period, out of 1,, deferred annuities contracts which became due, only 11, investors preferred the annuity to the lump sum.

    Another aspect that requires caution when extending our findings to other contexts is the possible existence of a status quo bias in favour of annuitisation. Indeed, Italian workers typically hold a large fraction of their wealth in an annuitised form.

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    Brown / Mitchell / Poterba | The Role of Annuity Markets in Financing Retirement |

    The existence of a bias in favour of the status quo ante is well documented see e. Kahneman et al. For example, concerning the topic of our study, it appears that in the U. Under-annuitisation can be socially inefficient even if it is efficient from an individual point of view: for example it might be rational for the individual to cash out pension wealth and spend it immediately after retirement, thereafter relying on social assistance. However, by doing this individuals do not take into account that they are imposing a negative externality on taxpayers.

    See Mitchell et al. James and Song, op. A similar arrangement has been adopted in Sweden, where the State has a monopoly over annuity provision. We are grateful to Daniele Franco, Giorgio Gobbi, Sandro Momigliano and two anonymous referees for encouragement and many helpful suggestions.

    The views expressed in the paper are our own, and do not necessarily reflect those of the Bank of Italy. Skip to main content Skip to sections. Advertisement Hide. Once you start taking distributions, you receive a regular check, always for the same amount. The defining characteristic of a fixed annuity is that during its interest-accumulating phase, the rate of interest you earn is guaranteed.

    In this regard, a fixed annuity is more similar in nature to a certificate of deposit CD than it is to a stock or mutual fund. Also because of this feature, fixed annuities are not classified as securities. Therefore, the SEC does not regulate them, and a person who sells them is not required to maintain a Series 7 or Series 63 license. Life insurance agents , most of whom are not licensed to sell securities, love to sell fixed annuities, in no small part because the commissions are huge.

    A variable annuity is so named because its interest rate varies based on the investment tool to which it is tied. Most variable annuities are invested in mutual funds, which are bundles of stocks, bonds and money market instruments. Because these investment vehicles, in particular stocks, vacillate based on economic conditions, variable annuities expose you to risk during recessions. During a variable annuity's accumulation phase, your balance hopefully will increase due to interest.

    However, when a recession hits, it is possible your balance will decline if the investment vehicle where it is parked contracts in value. While fixed annuities do not pose this risk, they also do not stand to grow your balance as much during good economic times. How annuities perform in a recession depends on the type of annuity and its investment strategy. For instance, if you are invested in an equity-indexed annuity and the stock market tanks, you will likely earn only the guaranteed minimum interest with very little gains.

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    On the other hand, if you have a fee-only annuity, which is free of commissions and surrender penalties, you have a lot more options, such as moving the capital into investments that perform well in a recessionary environment, or using some of the money for short selling. As for the insurance backing the annuity, it is generally safe no matter the market backdrop, as the insurance industry is highly regulated and is required to hold a certain amount of reserves to meet liabilities. Investopedia uses cookies to provide you with a great user experience. By using Investopedia, you accept our.

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