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Defined Contribution Plans, Mortality Risk, and the Demand for Annuities

Defined Contribution Plans, Mortality Risk, and the Demand for Annuities. James Poterba MIT and NBER Longevity 5 Conference, September 2009. Outline. Shifting Composition of Retirement Saving: Rise of Defined Contribution Plans

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Defined Contribution Plans, Mortality Risk, and the Demand for Annuities

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  1. Defined Contribution Plans, Mortality Risk, and the Demand for Annuities James Poterba MIT and NBER Longevity 5 Conference, September 2009

  2. Outline • Shifting Composition of Retirement Saving: Rise of Defined Contribution Plans • Current Patterns of Payouts and Annuity Demand in Self-Directed DC Plans • Implications of DC Plan Growth for the Demand for Longevity Insurance

  3. U.S. Private Retirement System: Shift from DB to DC • 1980: Roughly 75% of Pension Contributions in the U.S. to Defined Benefit Plans • 2005: 73% of Pension Contributions to Defined Contribution (401(k), 403(b)) Style Plans • DC Plan and IRA Assets in 2006: $8.3T ($16.4T in Total Retirement Assets) • Future Retirees will Have Lifetime Exposure to 401(k)s

  4. Retirement Asset Landscape, 2006 • 401(k) Plans: $2.7T • 457 and 403(b) Plans: $834B • IRAs: $4.3T • Private DB Plans: $2.3T • State/Local DB Plans: $3.0T • Federal Plans: $1.1T

  5. Private-Sector Pension Participation Rates, 2008 • Full-Time Workers: • 24% in Defined Benefit Plans • 51% in Defined Contribution Plans • 60% in Some Pension Plan • Part-Time Workers: • 10% in Defined Benefit Plans • 18% in Defined Contribution Plans • 23% in Some Pension Plan

  6. 401(k) Eligibility & Participation Rates, 1984-2003 SIPP

  7. Cohort Patterns of 401(k) Participation

  8. 401(k) Balances Among 401(k) Participants

  9. Accumulation Potential in 401(k)s (Purcell 2007) • Married Couple Contributing 8% of Salary for 30 Years • Historical Returns (pre-2008) on Equities • Median Balance at 65 for Median Earner: $468,000 • 25th Percentile Earner: $289,000; 75th Percentile $706,000

  10. Median Replacement Rates for 401(k)-Participating Retirees, 2035 (Holden & VanDerhei, 2005)

  11. Ratio of Projected Defined Contribution Plan Assets to Defined Benefit Plan Liabilities

  12. Recent Events and DC Accumulation Profile • 401(k)s Lost $500B Between June 30 and December 31, 2008 • Employer Cutbacks in 401(k) Generosity • Regulatory Swing Away from DC Model – But to What? • Open Issues: Incentives for Expansion of Pension Coverage, “Auto-Enrollment,” Government-Funded Plans for Low Income Households

  13. The New Focus: Drawing Down Assets in Retirement • Search for Simple Rules: X% Per Year? Simple Rules May Be Dominated • With Uncertain Longevity, No Bequest Motives or Medical Spending Shocks, Individuals Should Fully Annuitize • More Complex Analysis: Potential Medical and Nursing Home Costs, Bequest Motives – Annuity Demand is Reduced

  14. Longevity Risk is a Key Factor in Translating Assets into Lifetime Income Security • Conditional on Age 65, Probability of Dying by 75 is 0.254 for Men, 0.189 for Women • Conditional on Age 65, Probability of Living to 90 is 0.181 for Men, 0.275 for Women

  15. Dispersion of Longevity Outcomes for Married 65-Year-Old Couple • 38.4 Expected Remaining Person-Life-Years • 13.5 Expected Years Together • Expected Years Lived by Widowed Wife: 6.8 • Expected Years Lived by Widower: 4.5 • First Death: 25% Chance by Age 73, 50% by Age 78 • Second Death: 50% Chance After Age 90, 25% After Age 93 • Prob(Wife Survives Husband) = 57.5%

  16. Factors the Influence Annuity Demand • Understanding of Mortality Risk • Employer Provision of Annuity Options to Employees in DC Plans • The Cost of Annuities • Demand for Late-Life Liquid Assets • Bequest Motives • Concerns Related to Medical Costs

  17. Mortality Perceptions • Hurd / McGarry Compare Subjective Mortality Probabilities in Health and Retirement Survey with Actual Mortality Rates • Men: Survey Average Survival Probability to Age 75: 0.622. “Actual” from Mortality Table: 0.594. Women: 0.663 and 0.746. • Survival to 85: Subjective 0.388 for Men (0.242 “actual”), 0.460 (0.438) for Women

  18. Life Expectancy for 65-year-old Males, by Birth Cohort

  19. What Do DC Plan Participants Choose? • DB Plan Evidence (Mottola/Utkus): Active De-Annuitization and Lump Sum Demand • ICI Study 1995-2000 Period: Only 23% of DC Plan Participants with Choice at Retirement Chose Annuity • Oregon Public Employees Study (Chalmers/Reuter) – Poor Health, Strong Recent Stock Market Returns Reduce Annuity Demand

  20. Annuity Choices of TIAA-CREF Participants, 1989-2001

  21. Payout Options in Large Defined Contribution Plans, 2000 NCS • Only 38% of 401(k) Plans, 33% of All Defined Contribution Plans Offer an Annuity Option • Lump-Sum Distribution is the ONLY Option in 28% of 401(k) Plans, 30% of All DC Plans • Why?

  22. Offering Annuities Imposes Fiduciary Liabilities on Employers • Annuitizing within DC Plan: Employer Must Select Annuity Provider • Long-Term Financial Health Difficult to Gauge, Risk of Subsequent Lawsuit by Employees

  23. Annuity Options Available to Individuals • Sales of New Single-Premium Immediate Annuities: $12.8 Billion in 2007 • Variable Annuity Market is Much Larger but Very Few Assets are Annuitized • 2007 SCF: 9.5% of Households Aged 75-84 Report Receiving Income from Annuities • Annuitized Income Streams Approximately Half of Income for 65-74 Year Olds

  24. Explaining Small Private Annuity Markets • “DEMAND:” Precautionary Demand for Liquid Wealth, Bequest Motives, Informal Longevity Insurance Provided within Families • “SUPPLY:” Unattractive Annuity Prices Because of Adverse Selection or Limited Competition

  25. Expected Present Discounted Value (EPDV) of Annuity Payouts per Premium Dollar • EPDVNOM = Σt=1,TSt*ANOM/{Πj=1,t(1+ij)} • Survival Rates – Population Life Table or Annuitant Life Table, Projected Forward • Choice of Bonds for Discount Rates – Riskless Treasuries vs. Risky Corporates • EPDV Does Not Recognize Insurance Value of Annuity to Individual

  26. Money’s Worth of Individual Annuities, May 2009

  27. Why Are EPDV Values < 1? • Insurance Company Administrative Costs or Profits • Adverse Selection: Annuitant Population is Longer-Lived Than Population at Large • Risk Premium to Cover Cost of Future Mortality Improvement

  28. Adverse Selection: Comparing Mortality Rates for Annuitants & Population at Large, 2007

  29. Evidence of Adverse Selection: UK Compulsory Annuity Market • Nominal Annuity • Inflation-Indexed Annuity • “Escalating” Annuity (3% per year) • Nominal Annuity: For 65 year old males, 41% of EPDV is in First Five Years, 6% Beyond Age 85; Contrast with 34% (9%) for a Policy with 3%/Year Escalation (US 2008 Corporate Discounting)

  30. Five-Year Survival Probability, 61-65 Year Old Male Annuitant (Finkelstein-Poterba)

  31. A Key Concern: Late Life Medical Costs • CBO Projection for Cohort Turning 65 in 2010 • Any Nursing Home Use: 45% • One Year or Longer in a Nursing Home: 25% • Average Nursing Home Costs: $187/day for Semi-Private Room, $209/day for Private Room

  32. How Large is the Risk Premium for Aggregate Mortality Risk? • Forecasting Mortality is Difficult • Risk of Medical Breakthrough Could Change Experience • Life Insurers are Affected by Illness Shocks (1918 Influenza, AIDS) • How Does Correlation with Other Aggregate Shocks Affect Risk Charges?

  33. Share of Annuity EPDV From Payouts in First Five Years (2009)

  34. Annual Mortality Improvement Rate

  35. Lee-Carter Mortality Model and Monte Carlo Results on EPDVs • ln ma,t = αa + a*kt + εa,t with ma,t = crude death rate at age a in year t • qa,t = mortality rate, age a, year t = 1 – exp[- ma,t] • Aggregate Mortality Factor kt Follows a Random Walk with Drift • Estimate for {αa, a , kt} for Men over 1950-2007 Period (a = 65, …, 110) • Stochastic Simulation of Future Paths of Mortality Rates Can be Used to Compute EPDV of Annuities

  36. Potential Variation in EPDV of Annuity for 65-Year-Old Men, 2009

  37. Implications of Continued Growth of Self-Directed DC Plans • Absent Compulsory Annuitization (UK Model), Individuals Will Make Decisiosn About Annuitization • Marketing Longevity Insurance Products to Institutions Alone (Plan Managers, Pension Fiduciaries) Will Not Penetrate DC Universe • Longevity Risk Facing Insurers is Only One Factor Depressing Annuity Volume

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