Pension

Annuity Market

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 Throughout the 20th Century this has gradually been replaced by a model whereby individuals stop working some time before the end of their life and while still relatively healthy.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.


Subject to the individual living, an annuity provides a higher return than a standard savings product, because the annuity is an insurance product in which the individuals who die early cross-subsidise those who survive – a phenomenon called mortality drag. The advantage of buying the annuity-type product is that it allows a higher level of consumption, because of the mortality drag.


Nearly all annuities purchased in the UK – probably about 95 per cent – are paid for with a single premium (this follows automatically in the compulsory-purchase market) and most of these provide an income which is constant in nominal terms (‘level’ annuities), although other annuity products exist, for example, annuities which provide an income constant in real terms (‘index-linked’ annuities).


One concern that annuitants might have, is the possibility of dying very soon after purchasing the annuity. This would mean ex post that neither the annuitant nor the annuitant’s estate received much benefit from the transaction. It is an inherentfeature of all insurance products that if the insured event does not occur, the insured person loses the premium: however, it is often thought to be particularly problematic in the context of annuities. Partly to allow for this, it is possible to have an annuity with a guarantee period (of up to ten years), in which case the income payments for the guarantee period are paid regardless of whether the annuitant is alive or not – if the annuitant dies then the payments are made to their estate. Under new legislation an alternative form of annuity will be available from 2006 called ‘valueprotected’.

In this annuity product, the difference between the initial premium paid and the cumulated payments made to the annuitant (assuming this difference is positive) will be paid to the estate if the annuitant dies early, though the value protection element expires at age 75 under current legislation. All of the annuities discussed so far involve the payment of a premium followed by the receipt of an income that starts immediately. ‘Deferred’ annuities involve payment of a premium followed by an income stream that only starts at some point in the future. Such annuities are virtually never purchased by individuals: instead they are purchased in bulk by firms as part of a process of closing an occupational pension scheme.
The price of annuities depends upon a variety of factors, which can be summarized as follows:

• prevailing interest rates at the time the annuity is purchased;
• information available to the life insurer about the life expectancy of the annuitant
• the size of the premium paid for the annuity, which may also be related to life expectancy as wealthier individuals tend to live longer;
• the type of annuity purchased;
• the mark-up paid to the life insurer to cover its costs and profits.

It is predicted that the demand for annuity products will increase due to the demographics of an ageing population, and because of the continuing shift of workers between Defined Benefit (DB) and Defined Contribution (DC) pension schemes. The supply situation is more complicated because current annuity products are based on bonds and the state of the bond market is determined, to a large extent, by the UK government’s policies on the size and management of the national debt.A life annuity converts a stock of wealth at retirement into a flow of income that is payable to the annuitant until death. An annuitant pays a premium to a lifeassurance company who then undertakes to pay an agreed income to the annuitant, usually on a monthly basis. Because the life annuity is paid until the annuitant dies,it insures them against longevity risk, or in other words, it insures them against running out of savings to support consumption expenditure in old age. As with all insurance products, the effect is to re-distribute between individuals: those who are unlucky – paradoxically in this case it is unlucky to live too long – are subsidised by those who are lucky (i.e. those who live for a relatively short period).

Annuities are supplied in the UK by life-assurance companies who match their annuity liabilities with bonds or similar assets. The reason for this is that annuities typically pay a constant stream of income and, absenting mortality considerations, an annuity product is very similar to a bond product; it is also possible to have annuity-type products which are more similar to equity, but this market is underdeveloped. Given the current types of bonds purchased, life assurers can be seen as producers who take bonds as an input and produce annuities as an output.

A significant determinant of annuity rates is the economy-wide interest rate, in particular the bond market. Since rates of return on bonds are currently low it follows that annuity rates are also low. Of course, low bond yields are the result of a variety of factors, including overall government borrowing, monetary policy, international rates of return and the low inflation environment since the midnineties. So it is possible – at least in principle – that the government could influence annuity rates through either monetary or fiscal policy. In practice, however, these policy instruments are used to meet other objectives and monetary policy is undertaken by the Bank of England. Furthermore, the long-run effects of government policy on both the level and shape of the term structure of interest rates – especially if we consider real rather than nominal interest rates – are not well understood by economists.

The existence of annuities can be traced back to Roman times and a table of annuity rates calculated by Domitius Ulpianus from about 230 AD was used as late as the early modern period in Europe (Haberman and Sillett, 1995; Dyson, 1969). Annuities were used throughout the Middle-Ages and became popular with governments in the 17th Century as a method of raising money. The bases of modern actuarial science were developed during the eighteenth and nineteenth centuries alongside advances in probability theory and increasing availability of empirical mortality tables (Poterba, 2004). Because annuity products are illiquid, the UK government stopped using annuities as a primary means of finance from the 1690s onwards, converting the national debt into equity and bond instruments between 1694 (with the foundation of the Bank of England) and 1753 (with the consolidation of government bonds into a uniform issue of perpetual bonds – consols). Annuities were then increasingly issued by private companies, such as the Equitable Life Assurance Society (founded in 1762), and from then into the 19th Century there was a continuous growth of life-assurance companies and societies (although predominantly concerned with life assurance rather than annuity business).

The government continued to sell small quantities of annuities and life insurance as a means of financing the national debt, but increasingly realised the possible benefits of annuities, especially deferred annuities purchased with multiple premiums, to assist the elderly poor and sought to encourage sales by allowing sales throughfriendly societies (1819) or savings banks (1833) (Wilson and McKay, 1941). Gladstone introduced legislation in 1864 to sell annuities and life insurance through the post office, primarily due to the financial weakness of savings banks (Morley, 1903). Additional stimuli for the legislation were elements of empire building within the post office and paternalism towards the poor (Perry, 1992).

The provision of government annuities through the post office meant that the government was engaged more directly in competition with both private life assurers and friendly societies. These were politically powerful enough to ensure that minimum and maximum limits were placed on life insurance sales to restrict effective competition, but the restrictions on annuity purchases were less important. However, sales of immediate annuities from 1865 to 1884 only numbered 13,897 and deferred annuities for the same period were even fewer, totalling 1,043 (Perry, 1992). Even after the removal of the restrictions in 1882, sales remained poor: by 1907 the total number of insurance policies in force was 13,269 at the post office compared to 2,397,915 from life-assurance companies (Daunton, 1985). This was despite government insurance being sold at better prices and being virtually immune to default risk. With continuing low sales of both forms of insurance, and losses on government annuities, sales ceased in 1928.

The cessation of sales of government annuities may have had some effect on the private market (Norwich Union started selling annuities again in 1928), but by this time two further considerations also reduced demand for annuities. Many workers were now in either occupational pension schemes or state pensions. Among the more affluent middle classes demand would have been reduced by the tax treatment of annuities; the entire annuity payment was treated as income and taxed accordingly, despite the fact that some of the annuity payment was implicitly capital.

The 1956 changes introduced a new compulsory-purchase annuities market for those who had built up a personal pension fund, distinct from the existing voluntary annuities market. As noted in Finkelstein and Poterba (2002), these are likely to be quite different markets: only individuals who expect to live for a long time are likely to purchase a voluntary annuity, whereas compulsory annuities are purchased as part of the terms of the pension contract. Typical voluntary annuitants are female and relatively old (over 70), whereas typical compulsory annuitants are male and recently retired (about 65)

Hannah (1986) explains the evolution of a tax-free lump sum of 25 per cent of the pension fund. ‘The chapter of accidents which led in absurd progression to this situation, [the tax-free lump sum] which was initially desired by no one, began in the early years of [the 20th]century’ (Hannah, 1986, p.115). He notes that at the turn of the last century, occupational pensions varied widely in whether they paid a pension as a lump sum or as an annuity. There were arguments that suggested a lump sum would ease the progression from working to retirement, but against this was the concern that a lump sum would be frittered away. The Radley Commission on the Civil Service said in 1888: ‘The payment...of a lump sum is open to the obvious objection that in the event of improvidence or misfortune in the use of it, the retired public servant may be reduced to circumstances which might lead to his being an applicant for public or private charity’. The Tax-Exempt (1921) Act occupational directed that funds were not allowed lump sums by the Inland Revenue, though they could be paid by the pension out of non-tax exempt funds.

In 1971 one-third of private sector schemes paid a lump sum as part of the pension entitlement. This proportion had risen to more than 90 per cent by 1979. Immediately after its introduction in 1956 the compulsory-purchase annuity market had zero sales, since it would have been the young working cohort in the late 1950s who would have started saving through a personal pension, and it is unlikely that this cohort would have annuitised immediately. By the 1990s this compulsory annuity market was ten times larger than the voluntary annuities market, and will continue to grow as the percentage of the population with personal pensions grows. .

Source:
- Edmund Cannon and Ian Tonks, Survey of annuity pricing, Department for Work and Pensions, Research Report No 318
- Association of British Insurers (2004) The Pension Annuity Market: Developing a Middle Market (ABI, London).
- Johnson, P. (1985) Saving and Spending: The Working-class Economy in Britain 1870-1939 (Oxford University Press).
- World Bank (1994) Averting the Old Age Crisis (Oxford University Press).