Reforming Social Security: Lessons from Thirty Countries

Policy Reports | Social Security

No. 277
Thursday, June 09, 2005
by Estelle James

Paying Retirement Benefits

Table IV - Annuitization Rules

“Annuitization of the personal account ensures that retirees do not outlive their pensions.”

How can we be sure workers won’t spend all the money in their accounts before they die, then live at the minimum pension level, or worse, in poverty? Most countries with personal accounts require that workers annuitize or take their money out of the system in very gradual installments. Annuities are desirable because they guarantee workers a life-long income. However, retirees who need the money early — say, because they have high medical expenses — can’t get it. And if everyone is put into a community-rated annuity pool, those with short lifetimes (who are also disproportionately low-income earners) end up subsidizing those with longer lives (who are disproportionately high earners).

Can the private sector handle annuitization, given the inherent investment and longevity risk, as well as the inflation risk, if the annuities are price-indexed? The annuities market is currently tiny in practically every country — in part because in the past, defined benefit social security systems have paid public annuities, leaving little demand for the private market. How will this change if the defined benefit is partially replaced by individual accounts? Will annuities be offered on good terms? Will workers buy them if annuities are not required? The Chilean experience suggests that these problems can be resolved. Chile has the most extensive annuity market in the world. The annuities provide a good money’s worth ratio on price-indexed annuties. Life insurance companies sell more annuities than life insurance. [See the sidebar: "Case Study: Annuities in Chile."]

Annuitization in Eastern and Central Europe. All these countries require annuitization through insurance companies, except in cases where the accumulation is too small to make this feasible. Kosovo, for example, initially required annuitization, but has not been able to implement this requirement because accounts were simply too small. Other countries that require annuities may find this, too. They may also find that costs are higher and payouts lower than expected due to the absence of good mortality tables and the risk of longevity improvement. Many of these countries require that unisex mortality tables be used, so that women do not receive a lower monthly payment because of their greater expected longevity. It is not yet clear how this requirement will work in private insurance markets, where insurance companies prohibited from basing premiums on longevity, will try to enroll only those individuals who are good risks.

Annuities versus Programmed Withdrawals in Latin America. Either annuitization or gradual withdrawals are permitted in Latin America, but lump sum withdrawals are not allowed unless the pension exceeds a specified threshold. Generally, the threshold is 70 percent of a worker’s own wage and 120 percent to 160 percent of the minimum pension guarantee. [For more details and variations, see Table IV.] This is a compromise that enables retirees to get some of their money out early, but it is supposed to ensure that these withdrawals are not at the expense of a minimally acceptable lifetime income. Of course, for any of these arrangements to work well, good mortality tables are needed. Today, many Latin American countries face problems stemming from an undeveloped insurance industry and obsolete mortality tables.

“Most countries require annuitization or gradual withdrawals from accounts under strict regulations.”

Other Practices. Britain requires price-indexed annuitization of the mandatory contribution by age 75. Sweden requires annuitization, through the public sector. In Switzerland, annuitization is not required but it is usually the default option (pensions are annuitized unless the retiree deliberately requests some other payout mode). The Swiss government also sets the annuity terms at very favorable rates. Calculations from 1999 have shown that the present value of expected lifetime benefits is substantially greater than the premium — due to increases in life expectancy combined with decreases in interest rates.13 While this situation was unsustainable in private insurance markets, government regulations prevented efficient change. Starting in 2005, however, the conversion rate is scheduled to decline gradually from 7.2 percent of the premium per year until it reaches 6.8 percent in 2014.14 If current trends continue, that will still be a very good deal for retirees. The combination of favorable terms and default inertia has led 70 percent of all Swiss retirees to annuitize.

Lump Sum Withdrawals in Australia and Hong Kong. These countries deviate from the norm — they do not require annuitization or gradual withdrawals. Some analysts fear that retirees will spend down their accumulations quickly and thereby qualify for the means-tested old age pension. As a counter-incentive, Australia has recently instituted strong tax advantages for gradual withdrawals.

Figure IV - Percentage of Policies Annuitized in Chile%2C 1988-2002

Lessons for the United States. There is a trade-off between giving retirees control over their retirement funds versus ensuring that they will have an income even if they live 30 or 40 years after retirement. Mandatory old age plans exist precisely because we believe that a) not all individuals will make the right decisions, and b) if they become destitute society will have to pick up the bill. At the same time, some people desperately need their money earlier, perhaps to pay medical bills, and others know they will not live long after retirement. The latter group includes retirees in ill health and others with low life expectancy. The solution to this trade-off is to choose a guaranteed income threshold, after which lump sum withdrawals are permitted. The threshold should take into account that the poverty line or minimum pension is likely to rise over the retirement period, as the average wage and standard of living rise. For this reason, all countries have chosen a threshold well above the poverty line; the United States should follow this example.

Once a realistic threshold is reached, we should also consider exempting pensioners from the requirement to contribute further to their accounts. In Chile this exemption has increased their net take-home pay and therefore the labor supply of older workers— which is beneficial for the economy as well as the workers themselves. (Contributions to the traditional benefit should continue, however, because of its redistributive function.)

Of course, a number of other issues remain. Should joint annuities be required? Should variable annuities be permitted? Should gender-specific or unisex mortality tables be used? Should rate differentiation by socioeconomic group and DNA group be encouraged or allowed? Countries with personal accounts are only now beginning to confront these questions, and the United States will have to address them, too.

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