The Payout Phase For Pensions

Will Price

World Bank Pension Core Course

April 2013

The payout phase is a critical part of a pension system but

receives far too little attention. It is central to the ultimate

outcome of income security

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Economic and political Environment

Overall Framework – other pillars and key rules

Supervision

Market Structure, Entities and Conduct

Efficiency

Sustainability

Security

Coverage

Adequacy

Pension System Features Ultimate Outcomes

Payout phase has many different potential products, rules and

institutions.

• Products

• Lump Sums

• Phased Withdrawals

• Annuities (of differing types)

• Most countries restrict lump sums to ensure minimum annuitization

• Need to have the right capital market and regulatory structure for some

types of payments

• Risks of deliver can be born by insurance companies, pension funds, the

government and arms length government bodies – all have to deal with

core risks of longevity

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1997+25 years: IMSS DC Annuity Market starts (AFORE +

Gov MPG pays Ins Co. 2030 before many workers eligible

Invalidity & Occ Risk (IV+RT) AFORE balance, plus IMSS, plus Gov for MPG pays Ins Co annuity

ISSSTE Recognition Bond plus AFORE balance plus Gov MPG pay Ins Co annuity

Private Sector Insurance Companies supply annuities for IMSS + ISSSTE (DB Invalidity Pension

(IV+RT) (DC Retirement Pension -RCV), AFOREs offered Phased Withdrawals. Lump sums also taken.

Public sector (IMSS, ISSSTE and Government administers and pays for DB Bens (IV+RT +

RCV) part funded by part of the balances accumulated in AFOREs post 1997

1997 2007 2022 2030 2046 2052 2060

IV+RT IMSS under LSS73 - IMSS admin & Gov pays after AFORE balance

potentially new retirees until 2047 (1997 plus 48 year career to 65)

RCV IMSS 1973 Law - IMSS admin & Gov pays after AFORE balance used

RCV – ISSSTE – pre 2007ISSSTE admin and Gov pays after ISSSTE balance –

potentially until 2052 – 2007 and 45 year career to 60 (age of retirement in ISSSTE

rising from 51 in 2010 to 60 by 2028

Government pays basic poverty alleviation (e.g. 70 y Mas)

1997+25 years: AFOREs offer IMSS Phased Withdrawals

ISSSTE Recognition Bond plus AFORE balance – AFORE phased withdrawals

There are multiple – and often complex – mechanisms to payout

retirement income – as shown by this example of Mexico

There are a wide range of products and variations

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Risk Characteristics of Retirement Products for Pensioners

Protection offered Benefits provided

Longevity risk Investment risk Inflation risk

Retirement product Bequest Liquidity

Fixed real life annuities Yes Yes Yes Limited No

Fixed nominal life annuities Yes Yes No Limited No

Escalating real life annuities Yes Yes Yes Plus

Escalating nominal life …...

….. ..annuities

Yes Yes Partial Limited No

Variable life annuities,

.guaranteed benefits

Yes Yes Possible Limited No

Variable life annuities, bonus

payments

Shared Shared Shared Limited No

Variable life annuities, unit

linked

Shared No No Limited No

Lifetime phased …. …. … ..

..withdrawals

No No Possible Yes No

Term annuities No Possible Possible Yes No

Lump sum No Possible Possible Yes Yes

Self-annuitization No Possible Possible Yes Yes

Regulation needs to determine who will provide any given product

Centralized provision as adopted in Denmark and Sweden

Advantages: Large risk pooling; Scale Economies; Risk sharing

Disadvantages: Political interference in annuity pricing possible; Political

interference in asset management

Decentralization as in Chile and UK also has risks and advantages

Using individual choice has the same issues during the accumulation phase

You can combine decentralized provision with auctions to tackle issues with sales

agents

Bulk auctions also a possibility

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There are a range of risks that are being transferred when

moving from accumulation to payout

ShortfallEquities

BondsInsured

Liabilities

Before

Risk removed

ShortfallEquities

Subset of liabilities typically targeted

Risk removed

ShortfallEquities

Bonds

Subset of liabilities typically targeted

Risk removed

Shortfall 1

Subset of liabilities typically targeted

1 Shortfa l l pa id ei ther immediately or crysta l l i sed into a series of regular known payments2 Diagram shows pos i tion just before issue of individual member pol icies

Source: LCP Pansion Buy-ins, Buy-outs and Longevity Swaps 2012

Full buy-out

Insurance

Policy

Insured

Liabilities

Pensioners Non-pensioners

Buy-in

Insurance

Policy

Interest

rate risk

Inflation

risk

Asset

risk

Longevity

risk

Longevity swap

Interest

rate risk

Inflation

risk

Asset

risk

Longevity

riskResidual

Liabilities

Insured

Liabilities

Pensioners Non-pensioners

Residual

Liabilities

Hedged

LiabilitiesBonds

Interest

rate risk

Inflation

risk

Asset

risk

Longevity

risk

Pensioners Non-pensioners

The Chilean’s pioneered an auction approach

Mexico has also established an auction platform

The ‘value’ of an annuity can be compared using a Money’s

Worth Ratio – with care to ensure they are properly constructed

Money's Worth Ratios in Selected Countries Computed with Cohort Annuitant Table and Risk-Rate

Australia Canada Switzerland UK 1 UK UK 2 UK 3

(James) (James) (James) (James) (Cannon) (James) (Brown)

Nominal Annuities

Male, Age 55 - - - - - 0.921 0.934

Male, Age 65 1.013 0.981 1.046 - 0.977 0.908 0.927

Female, Age 55 - - - - - 0.928 0.937

Female, Age 65 1.002 0.976 1.036 - 0.979 0.907 0.927

Joint 0.988 0.98 0.985 0.981 0.987 - 0.929

Indexed Annuities

Male, Age 55 - - - - - 0.867 -

Male, Age 65 - - - - 0.887 0.854 0.822

Female, Age 55 - - - - - 0.876 -

Female, Age 65 - - - - 0.877 0.857 0.782

Joint - - - - 0.88 - -

Rocha and Thorburn (200&) citing various sources

Notes: 1 Cannon and Tonk's estimate is the overall average, 2 for males 60 and 65 and females 60 and 65; 3 MWR

for indexed annuities in the U.S. relate to annuities offered by Irish Life of North America (ILONA), which have

never been sold

Regulation of Providers has wide range of

considerations

• Prudential rules – insurance based options like Solvency II but

modern risk based solvency capital can be difficult

• Who and how do you choose allocation of risk

• Investment allocation rules

• Risk based supervision

• Availability of capital market instruments

Conclusion

• Payout is fundamental – needs to be tackled urgently

• Can’t say what you pension system is trying to achieve without

setting out pay out phase

• Need to chose type of product –annuities only product that

guarantees income till death

• Type of institution

• Type of regulation

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Will Price

willprice@worldbank.org

www.worldbank.org/nbfi/pensionfunds

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