Selection Effects in the Market for Individual Annuities: New Evidence from the United Kingdom

Abstract

The market for individual annuities has recently attracted substantial attention as Social Security reform proposals have been advanced in various countries.Some proposals call for partly or fully replacing government-provided defined benefit, pay-as-you-go retirement systems with defined contribution systems in which individuals would accumulate assets in individual accounts.In such systems, one important question concerns the way in which individuals would draw down their asset balances during retirement.The government might provide annuity products that would spread retirement income over many years and provide insurance against the risk of outliving one's resources.Alternatively, individuals could be required to purchase annuity products from private insurance firms.Another option is to allow individuals to decide whether or not to annuitize any of their assets.The relative attractiveness of these three options depends critically on whether reasonably priced individual annuities are available in the private annuity market.Most empirical research on annuities markets has focused on the United States.Examples include Friedman and Warshawsky (1988, 1990), Warshawsky (1988), and Mitchell, Poterba, Warshawsky and Brown (hereafter MPWB) (1999).These studies emphasize the limited size of the individual annuity market in the United States, and the non-trivial difference between premium charges and the expected present discounted value of annuity payments for a typical individual.This difference is in part the result of adverse selection.The individuals who choose to purchase annuities in private markets tend to be healthier, and to live longer, than those who do not buy annuities.The extent of such adverse selection is likely to depend on the institutional setting in which annuities are sold.The annuity market in the United Kingdom is much larger than that in the United States, particularly when scaled relative to population or national output.It has also begun to attract research attention in the context of current Social Security reform discussions.Murthi, Orszag, and Orszag (1999), for example, provide some empirical evidence on the pricing of different products in the U.K. annuity market.At least three features of the British market make it especially valuable for studying the operation of private annuity markets.First, in the United Kingdom there is both a compulsory private annuity market for individuals in various pension schemes, and a voluntary private annuity market for individuals who wish to annuitize some of their non-pension savings.The simultaneous operation of these markets provides an opportunity to

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