Pension Payouts. Risks and

Alternatives

Solange Berstein

Superintendent of Pension Fund

Administrators, Chile.

Agenda

Product design

The Chilean Experience

Why do people annuitize?

Money worth ratios

Intermediation of retirement products

Conclusions

Design of Pension payouts

Myopic behavior at the accumulation phase: Is it

over at time of retirement?

Risks faced during the accumulation phase: Are

they the same during retirement?

Tolerance towards risk during accumulation: Are

they the same during retirement?

Preferences during accumulation phase: Are they

the same during retirement?

Design of Pension payouts

If myopia is not a problem: Strong case for lump-sum.

Risks at retirement: Longevity risk

Financial risk

Interest rate risk (Affect timing of retirement)

Inflation risk

Tolerance to these risks may decrease at retirement

Consumption preferences may differ: Bequest motive becomes more relevant.

Different pension options provide different coverage for these risks

Selecting Among Pension Options

Annuities:

Provide longevity risk coverage.

Provide financial risk coverage.

Do not fulfill bequest motive.

Decision is definite.

Programmed Withdrawal

Funds remain in participant’s account

Remaining funds upon death constitute bequest.

Allow to postpone annuitization decision.

More complex pension options

Alternative options have been designed in order

to combine advantages of these pension types.

Longevity protection plus bequest:

Annuity with guaranteed period

Temporary Programmed withdrawal with differed

annuity.

Longevity protection plus financial premium:

Variable Annuity

The Chilean Experience

Pension Regulation

In Chile, all pension products must be inflation

indexed and joint. Survivor beneficiaries are

defined by law.

Lump sums are allowed only if remaining

balance is enough to finance 150% of Minimum

Pension and 70% Replacement Rate.

Early retirement is allowed if balance is enough

to finance 150% of Minimum Pension and 61%

Replacement Rate. (To become 70% in 2010)

High rate of Annuitization in Chile

PENSION CHOICE, AS OF SEPTEMBER 2007

Constant Real

Annuity

Guaranteed for

a Period; 40549;

50%

Programmed

Withdrawal;

30768; 38%

Constant Real

Annuity; 9838;

12%

High rate of Annuitization in Chile:

Possible Explanations. Strict limits to Lump-Sum

No DB plans or alternative provision of longevity insurance besides Minimum Pension Guarantee.

Marketing Advantages to Insurance Companies.

Brokers in insurance market, but not for AFPs.

Fee structure.

Early retirement. (Combined with marketing efforts from Insurance Companies)

Competitive annuity market, gives participants good value for their money.

Source: James, Martinez, Iglesias (2005)

High Money Worth Ratios.

Source: James, Martinez, Iglesias (2005)

High Money Worth Ratios.

Money’s Worth Ratios for Chile Estimated by this Report, 1999 and 2003 March 1999 March 2003

RV-04 Cohort

Risk-free rate

Average

RV-04 Cohort

Risk-free rate

Average

RV-04 Cohort

Corporate bond rate

Average

Male, 65 0.996 1.069 0.955

Male, 55 0.981 1.049 0.897

Female, 60 1.021 1.077 0.971

Female, 55 0.994 1.049 0.905

Joint 0.998 1.050 0.892

Source: The World Bank (2006)

Sustainability of high MWRs

Annuity Rate and Interest Rates on Central Bank Bonds

and Corporate Bonds (% p.a.), 1993-2005

2%

3%

4%

5%

6%

7%

8%

9%

10%

1993 1995 1997 1999 2001 2003 2005

Annuity Rate (RV-04) Central Bank Bonds Corporate Bonds

“Since the early 2000s the average annuity rate has exceeded the risk-free rate, a result

which is unusual by international comparison”. (The World Bank (2006))

The SCOMP: electronic market for annuities

The SCOMP

Electronic

market for

annuities:

Closed market for

companies

allowed to sell

annuities or

programmed

withdrawals

(6 AFP, 23 LIC,

751 brokers)

Blind system:

All companies

receive relevant

data of a potential

pensioner and

voluntarily make

offers

Several

possibilities:

Bargain (offer

must exceed

minimum offered

in SCOMP)

Auction

Allow each

individual to

obtain, at no

cost, all relevant

offers of

annuities or PW

for her.

1. Makes quotes

through an AFP,

Insurance Company

or broker

Affiliate

5. Informs

the Affiliate

Affiliate

• Make a new quote

• Select an offer and obtain a pension

• Request an external offer

• Desist from pensioning

• Request a bidding process

6. After receiving offers affiliate may choose

between the following options:

2. Participant

sends quote to

the system.

3. System

sends quotes to

suppliers

4. Suppliers

send pension

offers to the

system

What does SCOMP do?

AFP

Life

Insurance

Companies

Insurance brokers

Participants Suppliers

AFP

Life

Insurance

Companies

System

We want people to take well informed

decisions

Percentage

of requests

accepting the

best offers

PENSIONEERS THAT ACCEPTED THE HIGHEST OFFER

46,52

52,30

50,77

49,14

38,77

42,77

50,1351,58

36

40

44

48

52

56

Ene-05

Feb-0

5

Mar

-05

Abr-

05

May

-05

Jun-0

5

Jul-0

5

Ago-

05

Sep-0

5

Oct

-05

Nov-

05

Dic

-05

Ene-06

Feb-0

6

Mar

-06

Abr-

06

May

-06

Jun-0

6

Jul-0

6

Ago-

06

Sep-0

6

Oct

-06

Nov-

06

Dic

-06

Ene-07

Feb-0

7

Mar

-07

Abr-

07

May

-07

Jun-0

7

Jul-0

7

Ago-

07

Sep-0

7

%

Difference between the highest offer and the

one that was accepted

1,511,151,36

2,68

3,12

2,10

0,00

0,50

1,00

1,50

2,00

2,50

3,00

3,50

Ene

-05

Mar

-05

May

-05

Jul-0

5

Sep

-05

Nov-

05

Ene

-06

Mar

-06

May

-06

Jul-0

6

Sep

-06

Nov-

06

Ene

-07

Mar

-07

May

-07

Jul-0

7

Sep

-07

%

Constant Annuity Constant Annuity with a Guaranteed Period

What do people think about their

choice?¿Did you choose the highest offer?

79%

19%

2%

Yes No NR

Base Encuesta IPSOS

MAYO 2006

46% of pensioners under life

annuity that think they have

chosen the higher offer did not

really chose the highest offer.

50% of the ones that think they

did not choose the highest offer

are comfortable with their

decision.

Average difference between the highest offer and the lowest one entered to SCOMP for regular and

guaranteed annuities

10,37

7,16

9,307,77

0,00

2,00

4,00

6,00

8,00

10,00

12,00

Ene

-05

Mar

-05

May

-05

Jul-0

5

Sep

-05

Nov

-05

Ene

-06

Mar

-06

May

-06

Jul-0

6

Sep

-06

Nov

-06

Ene

-07

Mar

-07

May

-07

Jul-0

7

Constant Annuity Constant Annuity with a Guaranteed Period

Dispersion in MWR has decreased after SCOMP

Mean, Standard Deviation and Coefficient of Variation of MWRs in Different Years March 1999 March 2002 March 2003 March 2004 March 2005

Bottom

Third

All

MWRs

Bottom

Third

All

MWRs

Bottom

Third

All

MWRs

Bottom

Third

All

MWRs

Bottom

Third

All

MWRs

Mean 0.980 0.980 1.077 1.080 1.034 1.036 1.060 1.064 1.055 1.062

Std. Dev. 0.049 0.049 0.041 0.047 0.043 0.042 0.042 0.045 0.041 0.045

Coef. Var. 4.956 5.009 3.807 4.363 4.137 4.074 3.942 4.239 3.928 4.245

Source of raw data: SVS

“The drop in broker’s commissions after 2000 reveals that the draft Law was credible and

the effects of its future approval were being strongly anticipated by market participants.

However, the full adjustment of the market could only be expected after the realization of

the expected event, that is, the approval of the Law in August 2004 and its implementation

in the following months.” (The World Bank (2006))

Dispersion in MWR has decreased after SCOMPMWRs and Premiums in 1999 and 2005

MWRs and Premiums in 1999

0.7

0.8

0.9

1

1.1

1.2

0 2000 4000 6000 8000 10000 12000

Premium (UF)

MW

R

MWRs and Premiums in 2005

0.7

0.8

0.9

1

1.1

1.2

0 2000 4000 6000 8000 10000 12000

Premium (UF)

MW

R

Source: The World

Bank (2006)

The reduction in the dispersion of MWRs was stronger at the lower end of the market

Conclusions

Design of pension payouts and regulatory options may

shape decisions taken by individuals.

Even as important as the pension products that are

available is the design of the transition from

accumulation to decumulation phase.

Better information and a more competitive market may

improve options available to retiring individuals.

Although it is still early to assess the effect of SCOMP,

it may have contributed in this direction.