The Role of Real Annuities and Indexed Bonds in an Individual Accounts Retirement Program

Abstract

It is better to have a permanent income than to be fascinating." -Oscar Wilde, The Model Millionaire: A Note of AdmirationThe current US Social Security system provides retirees with a real annuity during their retirement years.After a worker's Primary Insurance Amount has been determined at the point of retirement, the purchasing power of Social Security benefits remains fixed for the balance of the individual's life.This is accomplished by indexing retirement benefits to annual changes in the Consumer Price Index (CPI).Hence retirees are insulated from inflation risk, at least as long as their consumption bundle is not dissimilar to the bundle used to compute the CPI.Several current reform plans propose to supplement, or partially replace, the existing definedbenefit Social Security system with mandatory individual defined contribution accounts (cf.Gramlich, 1996;Mitchell, Myers and Young, 1999; NASI, 1998).In most "individual account" plans, retirees would be required to purchase an annuity with all or part of their accumulated account balances.Yet the existing market for individual annuities in the United States is small, the expected present value of annuity payouts is typically below the purchase price of the annuity, and virtually all annuities currently available offer nominal rather than real payout streams.This has led some to argue that individual account plans would expose retirees to inflation risk that they do not currently face, in that they might purchase nominal annuities with their accumulated funds.In this paper, we explore four issues concerning real annuities, nominal annuities, and the inflation risks faced by prospective retirees, all of which are relevant to the prospects for individual accounts under Social Security reform.We begin by describing the annuity market in the United Kingdom.Annuitants in the U.K. can select from a wide range of both real and nominal annuity products.The U.K. annuity market demonstrates the feasibility of offering real annuities in the private marketplace.Moreover, the current U.K. annuity market may indicate the direction in which the U.S. annuity market will evolve, since indexed bonds promising a fixed real return to investors have been available in Britain for nearly two decades.The availability of such bonds has made it possible for U.K. insurers to offer real annuity products without bearing inflation risk.Similar bonds have been available

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